The $65 Trillion hole in the global finance system
How big is $65 Trillion? Imagine spending $10 million a year, every year for the rest of your life, and you still wouldn't be able to spend $1 billion. $65 Trillion is 65 Thousand Billions.
It’s more than 2 1/2 times the size of the entire US Treasury market, the world’s biggest. It’s 14% of the value of all financial assets globally, according to a tally from the Bank for International Settlements.
It’s also the value of hidden dollar debt unrecorded on the balance sheets of non-US banks and shadow banks as of June this year, also according to the BIS, the central bankers’ central bank. It has been growing rapidly, having nearly doubled since 2008.
What we are talking about here is hedge funds, private equity firms, sovereign wealth funds, just to name a few examples. Say what you will about the reckless and corrupt global banking system, at least they have enough regulations that we can at least have some idea of the size and composition of their assets and liabilities.
This $65 Trillion number is opaque. We have no idea what it looks like, how it has been hedged, and who the counter-parties are. Thus when it finally implodes, no one will ever see it coming.
This $65 trillion of debt we’re talking about isn’t a set of straightforward loans or bonds: It’s the repayment obligations on foreign currency swaps and forwards. These are typically used by foreign banks and investors when they want to buy a dollar-based asset like a US Treasury bond.
Swaps and forwards are fully collateralized and so ought to be relatively safe for the counterparty. When someone uses a swap to borrow dollars, they in effect pay for them with their own currency and make a commitment to sell the dollars back at a certain date in the future, most often in less than a year.
Let me first translate something. Swaps and forwards are another term for derivatives. Which, for the sake of simplicity, can be thought of as essentially insurance contracts.
Yet even this article understated the dangers here.
Institutions outside the US are holding an estimated $65 trillion in "missing" dollar debt off their balance sheets, making it harder for policymakers to anticipate the next financial crisis https://t.co/NxoMOrZIKT
— Bloomberg (@business) December 5, 2022
For instance, the chart above shows $40 Trillion in unrecorded foreign exchanges, but Reuters reports that there is $80 Trillion in hidden foreign exchange swaps which "exceeds the stocks of dollar Treasury bills, repo and commercial paper combined."
The report also focused on findings from the recent BIS global FX market survey, which estimated that $2.2 trillion worth of currency trades are at risk of failing to settle on any given day due to issues between counterparties, potentially undermining financial stability.
Nothing to see here. Just $2.2 Trillion. Far more than the wealth of the entire American working class. Once again, the $2.2 Trillion number understates the potential problem. While $2.2 Trillion is the value of currency trades per day, around $5 Trillion of foreign-exchange derivatives gets traded every day. While these are generally U.S. dollars, most of this trading is happening outside of U.S. borders.
"Off-balance sheet dollar debt may remain out of sight and out of mind—but only until the next time dollar funding liquidity is squeezed," the analysts write. "Then, the hidden leverage in pension funds’ and insurance companies’ portfolios…could pose a policy challenge."
Finally there is the issue of liquidity.
Central bank quantitative easing has been the global policy following the 2008 crash. It's driven financial asset prices, such as stocks and bonds, to extreme levels. It's also help drive real estate prices to extreme levels, largely through massive purchases of mortgage-backed securities.
In countries like Japan, the Bank of Japan became the nation's largest holder of national debt, mortgages, and even corporate stocks. At one time the Swiss National Bank was the largest holder of stocks in Apple Inc. in the world. The Federal Reserve didn't go to these extremes, but it did buy trillions of dollars worth of mortgage-backed securities and treasury bonds.
In order to buy all of this debt, investors had to sell. Thus the number of investors has dropped significantly. On top of that, all of this buying without any regard for the underlying value has discouraged new investors because few want to "buy high" and hope for a bigger fool to sell to.
In addition to all of this is the consequences for all of this asset buying - price inflation. The central banks printed up mountains of cash to buy these assets, and while it only helped the most wealthy, it's cost is being pushed onto everyone. This has forced the Fed and all of the central banks to stop their buying and raise interest rates.
So what you've got with fewer and fewer investors is declining liquidity in what is supposed to be the safest and most liquid debt market in the world, and the world has noticed.
Soaring inflation is being met by rising interest rates, the slowing of central bank asset purchases and fiscal shocks, all of which are sucking liquidity, the ability to transact without dramatically moving prices, out of markets.
Violent, sudden price moves in one market can provoke a vicious loop of margin calls and forced sales of other assets, with unpredictable results.
“The market is so illiquid and so erratic and so volatile,” Elaine Stokes, a portfolio manager at Loomis Sayles, said. “It’s trading on every impulse and we can’t keep doing that.”
Policymakers are paying close attention to market plumbing and financial stability risks, with the vice-chair of the Federal Reserve last month warning a “shock could lead to the amplification of vulnerabilities”.
On top of that, the U.S. has decided to ratchet up tensions and threaten sanction upon our largest creditor - China. So what did China decide to do? What anyone with any common sense would do - China stopped loaning us money, and has begun letting their outstanding loans expire.
On top of all of this you have the fallout from the Fed raising interest rates faster than anyone else. This has caused the U.S. dollar to spike higher, which is fine for America, but is devastating to the developing world, which generally has to borrow in dollars rather than their own currencies. It seems like it's only a matter of time before several third world nations default on their dollar-denominated debts.
None of this means a global financial crisis is certain. But it does mean that the risks are increasing, and that our financial elites are not taking any steps to prevent it.