counter-party risk

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There Is No Surer Way To Destroy A Banking System Than Giving Depositors A Haircut

mullet 2

No, not that kind of haircut.

I’m talking about the kind of haircut where depositors lose a portion of their money. This can destroy confidence in a fractional reserve banking system, as depositors in other banks and other countries fear that they too might be forced to take a haircut, leading to mass withdrawals, leading to illiquidity. And — as part of an E.U. bailout of the Cypriot financial system this just happened in Cyprus:

Eurozone finance ministers have agreed a 10bn-euro (£8.7bn) bailout package for Cyprus to save the country from bankruptcy.

The deal was reached after talks in Brussels between the ministers and the International Monetary Fund (IMF).

In return, Cyprus is being asked to trim its deficit, shrink its banking sector and increase taxes.

For the first time in a eurozone bailout, bank depositors are facing a levy on their savings.

This attack on depositors will have clear implications for depositors and banks in other bailout-prone areas of the Eurozone — Spain, Italy, Greece, Portugal. If the EU is prepared to impose haircuts of up to 10% on depositors in Cyprus as part of a bailout package, which countries’ depositors will be forced to take a haircut next? Mattress-stuffing Cypriots will be 10% better-off than their compatriots with confidence in the banking system. Even if only 10% or 20% of bank customers in Spain choose to withdraw their funds, that has the potential to cause serious liquidity problems.

Whether or not this actually happens is another question — although with unemployment running high throughout the Eurozone, those with savings may be particularly wary of losing them. This decision — no matter how many times Draghi and Merkel and Barroso reassure the crowds — makes bank runs throughout the Eurozone much more likely as savers seek to avoid the possibility of a haircut by moving to cash or tangible assets.

And this madness was totally avoidable.

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Golden Cognitive Dissonance

Simon Jack of the BBC asks a question that many of us have already answered:

Gold v paper money: Which should we trust more?

Fortunately, this gives way to some relatively fair coverage:

Detlev Schlichter is a former banker and the author of Paper Money Collapse and he says the current system is fatally flawed.

“The problem is that what we use as money can be created and produced by the privileged money producers – which are the central bank and the banking system.They can produce as much of this money as they like. And so the supply of this form of money is entirely elastic, it is entirely flexible.”

Detlev Schlichter believes this will, ultimately, lead to people losing faith in our current system of elastic money and turning to something that does not stretch – like gold.

The key point to add to this of course is that gold is not just insurance against dilution, it is more importantly insurance against counter-party risk:

Counter-party risk is the external risk investments face. The counter-party risk to fiat currency is that the counter-party — in this case the government — will fail to deliver a system where that fiat money will be acceptable as payment for goods and services. The counter-party risk to a bond or a derivative or a swap is that the counter-party  will default on their obligations.

Gold — at least the physical form — has negligible counter-party risk. It’s been recognised as valuable for thousands of years.

Counter-party risk is a symptom of dependency. And the global financial system is a paradigm of interdependency: inter-connected leverage, soaring gross derivatives exposure, abstract securitisations.

When everyone in the system owes shedloads of money to everyone else the failure of one can often snowball into the failure of the many.

Unfortunately, the BBC then embarks on an inane and pointless discussion on the merits of gold as an enforced monetary standard, a completely different topic to whether or not individuals should trust paper assets or hard money.

DeAnne Julius of Chatham House is quoted as saying:

If the amount of money in the system was limited by pegging it to gold it would limit economic growth, which is the last thing we need right now.

I think to put your faith in gold as the basis of a country’s monetary system would be extremely foolish.

This is not actually true — every single historical example of the gold standard has allowed for the expansion and contraction of the money supply as per the market’s desire for money — it can be mined, it can be recirculated, it can be credited, it can be imported, it can be devalued, or it can be supplemented with silver and other substances. The “problems” with gold only really began in the 1930s when central banks started imposing policies of forced contraction over extended periods — ignoring true market preferences.

The gold exchange standard period, which followed WW2, was a period of unprecedented and unparalleled expansion, productivity growth, technological innovation, and financial stability.

The Bank of England’s recent report on the gold standard periods concluded:

Overall the gold standard appeared to perform reasonably well against its financial stability and allocative efficiency objectives.

The BBC concludes by quoting former Chancellor of the Exchequer Lord Lawson:

You can’t force a government to stay on gold, so therefore gold has no credibility.

Do you see the cognitive dissonance here? If we are to believe Lord Lawson, gold has no credibility, because governments have previously proven themselves untrue to their word. Surely the thing that has no credibility is not gold, but government promises? And that is the answer to the BBC’s initial question.

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Gold’s Value Today

Way back in 2009, I remember fielding all manner of questions from people wanting to invest in gold, having seen it spike from its turn-of-the-millennium slump, and worried about the state of the wider financial economy.

A whole swathe of those were from people wanting to invest in exchange traded funds (ETFs). I always and without exception slammed the notion of a gold ETF as being outstandingly awful, and solely for investors who didn’t really understand the modern case for gold — those who believed that gold was a “commodity” with the potential to “do well” in the coming years. People who wanted to push dollars in, and get more dollars out some years later.

2009 was the year when gold ETFs really broke into the mass consciousness:

Yet by 2011 the market had collapsed: people were buying much, much larger quantities of physical bullion and coins, but the popularity of ETFs had greatly slumped.

This is even clearer when the ETF market is expressed as a percentage of the physical market. While in 2009 ETFs looked poised to overtake the market in physical bullion and coins, by 2011 they constituted merely a tenth of the physical market:

So what does this say about gold?

I think it is shouting and screaming one thing: the people are slowly and subtly waking up to gold’s true role.

Gold is not just a store of value; it is not just a unit of account; and it is not just a medium of exchange. It is all of those things, but so are dollars, yen and renminbei.

Physical precious metals (but especially gold) are the only liquid assets with negligible counter-party risk.

What is counter-party risk?

As I wrote in December:

Counter-party risk is the external risk investments face. The counter-party risk to fiat currency is that the counter-party — in this case the government — will fail to deliver a system where that fiat money will be acceptable as payment for goods and services. The counter-party risk to a bond or a derivative or a swap is that the counter-party  will default on their obligations.

Gold — at least the physical form — has negligible counter-party risk. It’s been recognised as valuable for thousands of years.

Counter-party risk is a symptom of dependency. And the global financial system is a paradigm of interdependency: inter-connected leverage, soaring gross derivatives exposure, abstract securitisations.

When everyone in the system owes shedloads of money to everyone else the failure of one can often snowball into the failure of the many.

Or as Zhang Jianhua of the People’s Bank of China put it:

No asset is safe now. The only choice to hedge risks is to hold hard currency — gold.

So the key difference between physical metal and an ETF product is that an ETF product has counter-party risk. Its custodian could pull a Corzine and run off with your assets. They could be swallowed up by another shadow banking or derivatives collapse. And some ETFs are not even holding any gold at all; they may just be taking your money and buying futures. Unless you read all of the small-print, and then have the ability to comprehensively audit the custodian, you just don’t know.

With gold in your vault or your basement you know what you’re getting. There are other risks, of course — the largest being robbery, alongside the small danger of being sold fake (tungsten-lined) bullion. But the hyper-fragility of the modern banking system, the debt overhang, and the speculative and arbitrage bubbles don’t threaten to wipe you out.

Paper was only ever as good as the person making the promise. But increasingly in this hyper-connected world, paper is only ever as good as the people who owe money to the person making the promise. As we saw in 2008, the innovations of shadow banking and the derivatives system intermesh the balance sheets of companies to a never-before-seen extent. This often means that one failure (like that of Lehman brothers) can trigger a cascade that threatens the entire system. If you’re lucky you’ll get a government bailout, or a payout from a bankruptcy court, but there’s no guarantee of that.

Physical gold sits undaunted, solid as a rock, retaining its purchasing power, immune to counter-party risk.

I think more and more investors — as well as central banks, particularly the People’s Bank of China — are comprehending that reality and demanding the real deal.

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Identifying a Treasury Crash

Readers have asked my opinion on whether or not China and Russia’s recent treasury offloading spree amounts to the first phase of a potential Great Treasury Crash.

Here’s a reminder:

There are two very strong pieces of evidence here for dollar and treasury weakness and instability: firstly, the very real phenomenon of negative real interest rates (i.e. interest rates minus inflation) making treasury bonds a losing investment in terms of purchasing power, and secondly the fact that China (the largest real holder of Treasuries) is committed to dumping them and acquiring harder assets (and bailing out their real estate bubble). So the question is when these perceptions will be shattered.

A large sovereign treasury dumper like China with its $1+ trillion of treasury holdings throwing a significant portion of these onto the open market would very quickly outpace the institutional buyers, and force a small spike in rates (i.e. a drop in price). The small recent spike corresponds to this kind of activity. The difference between a small spike in yields and one large enough to make the market panic enough to cause a treasury crash is the pace and scope of liquidation.

Now, no sovereign seller in their right mind would fail to pace their liquidation just slowly enough to keep the market warm. After all, they want to get the most for their assets as they can, and panicking the market would mean a lower price.

But there are two (or three) foreseeable scenarios that would raise the pace to a level sufficient to panic the markets:

  1. China desperately needs to raise dollars to bail out its real estate market and paper over the cracks of its credit bubbles, and so goes into full-on liquidation mode.
  2. China retaliates to an increasingly-hostile American trade policy and — alongside other hostile foreign creditors (Russia in particular) — organise a mass bond liquidation to “teach America a lesson”.
  3. Both of the above.

Now the pace and scope of any coming treasury liquidation is still uncertain and I expect it to very much be dictated by how the Chinese real estate picture plays out — the worse the real estate crash, the more likely Chinese central-planners are to panic and liquidate faster.

So here’s the relevant data:


Clearly, what we would expect to see in the nascent phases of a crash is that blue line to spike while the other lines all decline significantly.

Does this look like that to you? Well, frankly, no. China’s holdings have merely declined to 2010 levels — hardly a nosedive, but certainly signifying China’s lukewarmness toward the Obama-Bernanke administrations. Right now they are just testing the water.

Significantly, rates have risen in the past few days, signalling that even in spite of all the QE and Twisting, Bernanke’s task remains volatile.

So — while it is all very easy and attention-grabbing to spew fear-mongering projections of an imminent crash — I have to be realistic. 2013 or 2014 or even later seems a much likelier timeframe for this momentous and historic eventuality. And of course, black swans can derail any projection. Humans will always be fallible, no matter how much processing power we put behind our prognostications.

So there is really no timeframe to my prediction. Certainly, Bernanke has proven himself to be a proficient can-kicker. Too many economists have scuppered their reputations by making timed predictions which fail to play out.

And my prediction is not an economic prediction, so much as a geopolitical one, and political science is an oxymoron; politics (like any other market — yes, it’s a market to be bought and sold) can swerve and tilt in any direction in the time-being, even while its broader historical trends are clear and evident. (In this case, the rise of China, the end of American primacy, and the death of the dollar as a reserve currency).

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The New Goldbuggery

In my travels across the internet, I often hear a disparaging label being thrown around to describe libertarians and adherents of Austrian economics: goldbug.

The Economist’s Free Exchange column from last July encapsulates this perfectly:

The disappointing thing about Ron Paul’s goldbuggery is the weakness of the analysis behind it. His support seems almost mystic in nature: that gold is money is a law of economics that’s held for 6,000 years! In his defence, this quasi-mystical belief in the sanctity of gold in a monetary system was shared by the world’s financial leaders for much of the industrial period. That’s not much of a defence, though. Gold worship repeatedly drove the economy into ditches and off cliffs, but for a few lucky years in which the pace of new gold discoveries fortuitously matched growth in the global economy.

I can do a pretty good job of analysing and deconstructing that (and indeed have already strongly questioned the claim that it was “gold worship” that drove the economy off a cliff in the 1930s) but in the interests of economic “progress”, I would rather outsource my analysis to China. If it’s good enough for Apple, it’s good enough for me.

More specifically, I want to outsource my analysis to Zhang Jianhua of the People’s Bank of China.

From Forbes:

Analysts believe China bought as much as 490 tons of gold in 2011, double the estimated 245 tons in 2010.  “The thing that’s caught people’s minds is the massive increase in Chinese buying,” remarked Ross Norman of Sharps Pixley, a London gold brokerage, this month.

So who in China is buying all this gold?

The People’s Bank of China, the central bank, has been hinting that it is purchasing.  “No asset is safe now,” said the PBOC’s Zhang Jianhua at the end of last month.  “The only choice to hedge risks is to hold hard currency — gold.”  He also said it was smart strategy to buy on market dips.  Analysts naturally jumped on his comment as proof that China, the world’s fifth-largest holder of the metal, is in the market for more.

Wow. This, more or less, is the argument about gold that I advanced last month:

[Gold] doesn’t do anything. It doesn’t create any return. It just sits. It’s a store of long-term purchasing power.

And most importantly it is a hedge against counter-party risk.

What is counter-party risk?

Counter-party risk is the external risk investments face. The counter-party risk to fiat currency is that the counter-party — in this case the government — will fail to deliver a system where that fiat money will be acceptable as payment for goods and services. The counter-party risk to a bond or a derivative or a swap is that the counter-party  will default on their obligations.

Gold — at least the physical form — has negligible counter-party risk. It’s been recognised as valuable for thousands of years.

Counter-party risk is a symptom of dependency. And the global financial system is a paradigm of interdependency: inter-connected leverage, soaring gross derivatives exposure, abstract securitisations.

When everyone in the system owes shedloads of money to everyone else the failure of one can often snowball into the failure of the many.

All-denominated fiat securities are touched by counterparty risk, because of the nature of the hyper-interconnected global financial system. Physical gold will still be physical gold, even after the dust settles, even after all the unpayable debt has liquidated, and after the new global financial order has taken shape. That is what Zhang Jianhua — and presumably the PBOC — have understood. For those who possess physical gold, there will be no haircuts or write-downs on that asset. There are precisely zero historical examples of gold-denominated hyperinflation.

This is an entirely different argument to claiming that the monetary base should solely consist gold, of course. The gold standard doesn’t seem to prevent credit-driven bubbles, because it merely restricts the size of the monetary base.

But gold has retained its moneyness, its for 6,000 years for a reason. While value is subjective, I would suggest that its liquidity, its freedom from counterparty risk, its fungibility, and above all its natural scarcity have played a huge part in that.

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All I Want for Christmas is…

An end to this bullshit.

Honestly, why is an inert and essentially useless metal like gold the best performing major asset class of the last ten years? It doesn’t do anything. It doesn’t create any return. It just sits. It’s a store of long-term purchasing power.

And most importantly it is a hedge against counter-party risk.

What is counter-party risk?

Counter-party risk is the external risk investments face. The counter-party risk to fiat currency is that the counter-party — in this case the government — will fail to deliver a system where that fiat money will be acceptable as payment for goods and services. The counter-party risk to a bond or a derivative or a swap is that the counter-party — in this case the debtor — will default on their obligations.

Gold — at least the physical form — has negligible counter-party risk. It’s been recognised as valuable for thousands of years.

Counter-party risk is a symptom of dependency. And the global financial system is a paradigm of inter-dependency: inter-connected leverage, soaring gross derivatives exposure, abstract securitisations.

When everyone in the system owes shedloads of money to everyone else the failure of one can often snowball into the failure of the many.

That, as much as anything else, is the real problem with all the policy that has gone into preserving at stabilising the financial system since 2008. It has preserved a system full of counter-party risk, where one big failure could snowball into the failure of the entire system.

Mark Spitznagel wrote a fantastic article for the WSJ a couple of days ago about the current shape of the global financial system:

The conifer’s secret to longevity lies in a paradox: Their conquest has been largely the result of episodes of massive forest destruction. When virtually all else is gone, conifers show their strength and prowess as nature’s opportunists. How? They have adapted to evade competitors by out-surviving them and then occupying their real estate after catastrophic fires.

First, the conifer takes root where no one else will go (think cold, short growing seasons and rocky, nutrient-poor soil). Here, they find the time, space and much-needed sunlight to thrive early on and build their defenses (such as height, canopy and thick bark). When fire hits, those hardy few conifers that survive can throw their seeds onto newly cleared, sunlit and nutrient-released space. For them, fire is not foe but friend. In fact, the seed-loaded cones of many conifers open only in extreme heat.

This is nature’s model: overgrowth, followed by destruction of the overgrowth, and then the subsequent new growth of the healthiest and most robust, which ultimately leaves the forest and the entire ecosystem better off than they were before.

Pondering these trees, it is not too much of a stretch to consider the financial forests of our own making, where excess credit and malinvestment thrive for a time, only to be destroyed—and then the releasing of capital into markets where competition has been wiped out. The Austrian school economists understood this well, basing a whole theory around this investment cycle.

Let’s hope that policy makers can grasp this reality and allow nature to do what she does best: change, renew and revitalise.

Merry Christmas, everyone.