Backstage Fire

By E. Pugh (artist), James Fittler (engraver) [Public domain], via Wikimedia Commons

The collapse in oil and commodity prices, among other things, is flagging up a sharp slowdown in the world economy, which has been the catalyst for a record number of hedge fund closures in recent months.

But that might be masking an even more concerning event that is most likely playing out right now on the secondary market. The secondary market is enormous in size and worth about 650 trillion USD, which equates to about 10 times the sum of global economic activity. 

Through the practice of leveraging (known as gearing in the UK) hedge funds leverage their investment (bets), typically by a ratio of 10 with the aim of maximising profits on the secondary market. So with one million USD of capital hedge funds increase the size of the bet to 10 million USD. Consequently, the size of the bets out there, are many times greater than the actual capital financing them.

Years of quantitative easing (QE), the cheap money available for those high up the food chain, such as the big commercial banks, have fuelled speculation on the secondary market to levels of insanity. In other words, not only has QE had an inverse impact on global economic growth, but it has also aided and abetted wild speculation on the secondary market. 

This multi trillion dollar market, probably more appropriately known as the shadow market, despite its enormous size, is rarely discussed in the mainstream. It is an opaque and unregulated market, operating almost under stealth with many of the funds registered in tax havens, sheltered from tax regimes. 

That being said, the secondary market where derivatives are traded has a useful function in the real economy, particularly for mining and oil companies, where prices fluctuate on global markets. Imagine putting together a business plan with the aim of raising capital to finance mining or drilling licenses, heavy machinery and labour required to mine a commodity or drill for oil. Forecasting the potential annual output of an oilfield or open pit mine is feasible, but predicting the commodity's price during the extraction phase is speculation. So if the oil or mining company is able to lock-in a given price for say a duration of two years, then revenue and profit forecast figures have value. For this reason, the company is likely to purchase a sell derivative contract, which locks in at today's price and the amount of the commodity that can be sold over a specified period of time, typically two years. Note that in this instance, while the company has shifted the risk onto someone else, the seller of the derivative contract, the risk of falling oil prices has not been eliminated but rather transferred to the financial system. 

Indeed, the risk of fluctuating commodity or oil prices has been absorbed by the hedge funds that buy and sell these derivative contracts on the secondary market with the aim of making a profit. In the example above, if oil prices were to rise, the fund makes a profit. Alternatively if oil falls they lose money.

However, due to leveraging, when the hedge funds make bad bets, their losses are magnified many times throughout the financial system. Those high up the food chain, the commercial banks, funnel the cheap money they receive from the central bank to juice the hedge funds, but when the funds get it wrong, the commercial banks also lose big. It is a zero sum game. For example, those oil companies and hedge funds that locked in oil prices before the crash are okay, but on the other side of their win contract is a loser, a commercial bank, which is magnified by a factor of ten. 

What happens in the secondary market (a horse betting game fuelled by years of cheap money and run by a few big players) has consequences for everyone else. When commercial banks make loses, there is less lending activity between the banks, credit becomes tight, interest rates rise, mortgage payments increase, servicing debt becomes more expensive and business investment falls off a cliff, with all the consequences that follow.

So to what extent have commercial banks invested in commodity derivative contracts? 

It has been estimated that six of the largest “too big to fail” banks control 3.9 trillion USD in commodity derivatives contracts. Moreover, a very large chunk of that amount is made up of oil derivatives.

What happens when many of these oil producers have locked in say, 100 USD a barrel and oil continues to slide to say 50 USD a barrel?

Oops!

The losses for being on the wrong end of the derivatives contract would be enormous.The derivative market works fine, except for those black swan events that nobody predicts.If the record closure of hedge funds is anything to go by, then a lot of players got caught out by the recent oil and commodity price collapse.That also implies that someone somewhere who underwrote these derivative contracts must be nursing a colossal amount of losses in commodities and oil derivatives.

Already there is a meltdown looming in the global credit market and now massive losses on commodity derivatives.

While the show displays a predictable normality, backstage there is a fire raging.