‘Brexit’, Derivatives And Unemployed Drinkers!

financial risk

Summary: Whether we work in real estate, on Wall Street or maybe in the manufacture of widgets…

What is the potential impact on global financial stability from a yes vote next week for Brexit?

On June 23, 2016 Britain will be holding a referendum that will decide whether or not the country will remain in the European Union!

For the purposes of this discussion the reasons surrounding the why, where and how behind this vote will take a backseat to one potential issue of concern if ‘Brexit’ wins, the global derivatives markets. In other words a potential unintended financial consequence to a political hot potato!

After the somewhat technical discussion below about derivatives is an anecdote that attempts to simplistically and loosely explain this incredibly significant product by way of a bar, its unemployed patrons and Wall Street bankers who discovered how to profit from both…Up to a point of course!

What Is A Derivative?

According to the International Swaps and Derivatives Association (ISDA), a derivative is a risk transfer agreement, the value of which is derived from the value of an underlying asset. More simply, a derivative is a contract between two parties where one party agrees to take on the risk of losses associated with a particular asset—such as a physical commodity or an agreed amount of currency

A derivative contract can base it value on different kinds of underlying assets such as a physical commodity, an interest rate, a company’s stock, a stock index, a currency, or virtually any other tradable instrument upon which two parties can agree. An over-the-counter (OTC) derivative is a bilateral, privately negotiated agreement that transfers risk from one party to the other.

Derivatives can either be over-the-counter—meaning a one-off, private, customized contract—or exchange-traded—meaning a standardized contract that is traded through an exchange.‘ (Source)

The size of the derivatives market is as huge as is the lack of understanding surrounding actual counter-party risk and all the triggers that could setoff a domino effect leading to a potential global financial crisis.

Nowhere was that more in focus than during the financial crisis of 2007-2008!

Using 2014 statistics this explains the notional versus gross derivatives contracts and the approximate dollar amount outstanding…

There is a big difference between the notional amounts of outstanding OTC derivatives contracts—the face value of the underlying asset—and the gross market value of the outstanding contracts themselves.

The notional amount is the actual value of the asset on which the contract is written, but parties to a derivative contract are seldom required to pay out the full value of the asset, hence the notional amount outstanding is seen as a poor reflection of the actual risk. The gross market value, in contrast, is the total amount paid by companies for outstanding contracts.

In the first half of 2014, OTC derivatives markets contracted. The notional amount of outstanding contracts totaled $691 trillion at end-June 2014, down by 3% from $711 trillion at end-2013 and back to a level similar to that reported at end-June 2013.

The gross market values of outstanding OTC derivatives continued to trend downwards in the first half of 2014. Gross market values was $17 trillion at end-June 2014, down by 7% from $19 trillion at end-2013 and 14% from $20 trillion at end-June 2013. Whereas, in 2013, the decline had been concentrated in interest rate derivatives, in the first half of 2014 the gross market value of foreign exchange derivatives also fell significantly.‘ (Source)

Britain Is An OTC Derivatives Hub!

Lastly and before we get to the anecdote below, the following is a brief overview from the law firm Allen & Overy of the potential ramifications from a ‘yes’ ‘Brexit’ vote…

‘The UK is important for the global derivatives markets:

 London is arguably the leading financial centre for OTC derivatives activity both in the EU and globally.

 Businesses established in the UK use EU financial services regulation to “passport” their derivatives services throughout the EEA.

 Businesses established outside the UK may use a UK “passport” (for example, by setting up a local branch or a subsidiary in the UK) as a way of accessing the UK and/or the broader EEA derivatives markets.

 A vast number of OTC derivatives contracts, whether or not involving UK entities, are governed by English law and include a submission to the jurisdiction of the English courts.

 Key elements of market infrastructure (for example, central counterparties (CCPs) for cleared OTC derivatives) may be established in the UK.

 Many derivatives contracts reference, or are settled in, Sterling or UK assets.

 Sterling and UK assets are routinely used as collateral in support of derivatives trading relationships.

If the analysts are right, there are a number of fairly obvious consequences which could play out in the derivatives markets:

(i) Deterioration in counterparty creditworthiness Businesses with significant exposure to the UK economy could find that their credit rating, or their counterparties’ view of their creditworthiness, is adversely impacted by Brexit. At best, this would be likely make it more expensive for those businesses both to enter into new derivatives (the cost of credit would be higher) and to maintain existing positions (for example, decline in creditworthiness may lead to new or enhanced collateralisation obligations in bilateral OTC derivatives contracts). At worst, the effect could be so significant as to trigger termination rights – whether ratings related or arising out of a real default of the credit-impaired counterparty.

(ii) Changes in exposures Fluctuations and volatility in relevant markets may create or increase mark-to-market exposures under existing derivatives contracts. This, in turn, would trigger obligations to post additional margin.

(iii) The value of UK-linked collateral could decline Where margin calls are, or have been, met by posting assets that are linked to the UK (such as Sterling cash or UK gilts), particularly to cover exposures measured in currencies other than Sterling, a deterioration in the value of those assets will also result in obligations to post additional margin – effectively compounding the potential adverse effects noted above.

To read a more detailed discussion please visit the link above. And now…

A Bar Owner, Unemployed Patrons And DrinkBonds

Of course the bar, bar owner and the patrons in the anecdote below are purely fictional while the depiction of Wall Street bankers may be somewhat closer to the truth!

Understanding Derivatives -

Heidi is the proprietor of a bar in Chicago.

She realizes that virtually all of her customers are unemployed alcoholics and, as such, can no longer afford to patronize her bar.

To solve this problem, she comes up with a new marketing plan that allows her customers to drink now, but pay later.

Heidi keeps track of the drinks consumed on a ledger (thereby granting the customers loans).

Word gets around about Heidi’s “drink now, pay later” marketing strategy and, as a result, increasing numbers of customers flood into Heidi’s bar. Soon, she has the largest sales volume for any bar in Chicago.

By providing her customers freedom from immediate payment demands, Heidi gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages.

Consequently, Heidi’s gross sales volume increases massively.

A young and dynamic vice-president at the local bank recognizes that these customer debts constitute valuable future assets and increases Heidi’s borrowing limit.

He sees no reason for any undue concern, since he has the debts of the unemployed alcoholics as collateral.

At the bank’s corporate headquarters, expert traders figure a way to make huge commissions, and transform these customer loans into DRINKBONDS.

These “securities” then are bundled and traded on international securities markets.

Naive investors don’t really understand that the securities being sold to them as “AAA Secured Bonds” really are debts of unemployed alcoholics. Nevertheless, the bond prices continuously climb, and the securities soon become the hottest-selling items for some of the nation’s leading brokerage houses.

One day, even though the bond prices still are climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi’s bar. He so informs Heidi.

Heidi then demands payment from her alcoholic patrons, but being unemployed alcoholics, they cannot pay back their drinking debts.

Since Heidi cannot fulfill her loan obligations she is forced into bankruptcy. The bar closes and Heidi’s 11 employees lose their jobs.

Overnight, DRINKBOND prices drop by 90%.

The collapsed bond asset value destroys the bank’s liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community.

The suppliers of Heidi’s bar had granted her generous payment extensions and had invested their firms’ pension funds in the BOND securities.

They find they are now faced with having to write off her bad debt and lose over 90% of the presumed value of the bonds.

Her wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.

Fortunately though, the bank, the brokerage houses and their respective executives are saved and bailed out by a multi-billion dollar no-strings attached cash infusion from the government.

The funds required for this bailout are obtained by new taxes levied on employed, middle-class, nondrinkers who have never been in Heidi’s bar.

Now do you understand?

(Source unknown)

Finally to use a phrase that the pundits on business news channels love to invoke, on June 23, 2016 all eyes will be on Britain and the ‘Brexit’ vote!

Michael Haltman is President of Hallmark Abstract Service in New York. He can be reached at mhaltman@hallmarkabstractllc.com

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