Clue Is In The Secondary Market

November 15, is likely to be an important date for traders.

Why? It's when the Bank of International Settlements is scheduled to releases its annual progress report on over the counter derivatives transactions. This data is likely to give traders/retail investors a valuable insight into where the market is heading.

The secondary market, or derivatives market is little known, rather mysterious and riddled with complex jargon so I will keep it in layman terms.

Basically, the secondary market is massive in size, it is worth approximately 650 trillion US dollars. To give meaning to that figure the secondary market is worth about 10 times the sum of the economic activity of all the countries in the world in 2013.

But only super capitalised investment banks have access to the secondary market, it is not open to the retail investor. Nevertheless, what happens in the secondary market has a big impact on us downstream. If those high up the food chain mess up on the secondary market we are left moping up the mess. We feel the pain in terms of plunging portfolio values, difficulty in taking money out of the bank, low interest rates on savings and job losses.

The secondary market has grown to such an enormous size in recent times due to leveraging.

What is leveraging?

Imagine we make a horse racing bet, you put 100 USD on the table and if your horse wins I give you 1000 USD dollars. If however, my horse wins you give me a 1000 USD.

So with little money there's the potential to win a lot, 10 times as much as I put on the table if my horse wins. But there is also the potential to lose a lot if I lose the bet.

This is precisely why the commercial banks are taking huge risks on the secondary derivatives market, the potential of making huge profits. How do you think the commercial banks can make a cool five billion dollars of profits every quarter, even in a down market?

They are leveraged up to their eyeballs in the secondary market, which includes mortgage backed securities, default swaps and credit debt obligations. These are derivatives, but for the purpose of keeping it simple I will refer to the whole secondary market as the horse race market.

So the horse race market is worth an absolute fortune, many times bigger than the world's economy and for a few heavyweight participants with deep pockets they have an opportunity to make or lose an absolute fortune in a small space of time. When the banks lose money on the horse race market it has a cascading effect and they are forced to sell like crazy, which causes disruptions to other banks. Then other banks are also forced to sell, it sparks off a chain reaction and the whole thing falls apart very quickly, similarly to the way a house of cards collapses.

This is unfortunately what happened in the 2008 financial crisis, which brought the entire financial system almost to its knees in a short space of time. It was a huge derivatives crash, in the secondary market, especially in mortgage backed securities which then triggered a credit squeeze and the economic recession that followed.

Pretty much everyone has been affected, either directly or indirectly by the financial crisis of 2008. That is why why we need to shed some light on this very important market. The Bank of International Settlements November 15 report will be a clue as to what the central bank will do next in the secondary market. Will the Quantitative Easing, bond purchasing program designed to keep interest rates low, be finally wound down or will QE be ramped up again. Perhaps the central banks might pump more liquidity into the system, they may not call it QE or a bond buying programme, nevertheless, they will find a way if necessary to continue injecting liquidity into the system.

In 2008 there was a major derivatives correction, it wasn't necessarily mortgages, it was mortgage backed securities, default swaps and credit debt obligations that fell apart. Again I will cut all this financial jargon out and just call the whole shebang horse racing bets, as they’re essentially the same thing. In 2008 total horse racing bets amounted to 650 trillion USD, a huge amount, then there was a significant contraction in horse racing bets to the tune of 50 trillion US dollars. Put another way, almost the entire world's GDP was wiped out in the space of just 6 months. Losses due to bad bets. This helps explain why the world economy went through such big problems in 2008 and why economies experienced such a server contraction.

Going back to the previous example of you putting 100 USD on the table and your horse winning, then me giving you 1000 USD dollars. So the notional amount is 1000 US dollars but the gross market value for your horse race is 100 USD.

Well back in 2008 the notional amount dropped by 50 trillion US dollars, that's a massive fall.

How did the central bank, the FED, respond?

The central bank reacted in the second half of 2008 by injecting approx 15 trillion dollars in the gross market value of horse bets.

So in the second half of 2008 notional amount of horse racing bets drops and the central bank stepped in by putting more money on the table and jumping up the gross market value of horse bets.

What happened to the stock market?

It went up and up... banks were able to speculate on the derivatives market, make more horse bets and the goldilocks economy spins on, until the second half of 2011.

Then what happened?

The notional amount of horse racing bets suddenly drops again, this time there is 30 trillion contraction in the total value of horse racing bets. The FED reaction is the same, but this time they put 8 trillion dollars on the table in the gross market value of contracts for horse racing bets and banks start purchasing derivatives again.

Then stockmarket continues its rally again and the goldilocks economy spins on.

So now we are in 2014 and if November 15 reports shows a huge drop in notional amount of horse racing bets..well you can write the bedtime story yourself, just repeat action and the goldilocks economy continues.