Late last year, we wrote several articles about a warning from the Bank for International Settlements about a $75 trillion unidentified loss in the foreign exchange markets.  Then, all went quiet for months, almost as if the problem had thankfully healed itself like a salamander regenerating a lost tail.  In the past few weeks, an issue has reappeared with concerns about an even more significant number, $1 quadrillion ($1,000 trillion).  This figure is beyond comprehension for most of us, so it just seems to go in one ear and out the other.  To understand how a number this large could exist in markets, and no one knows what it is comprised of and who owes whom, we must go back to the days of President Clinton.

Clinton Weakens

Banks and brokerage houses might have duped Clinton into repealing the Glass-Steagall Act and replacing it with the Financial Services Modernization Act, allowing banks and brokerage companies to merge again.  This combination of banking and brokerage led to the downfall of banks in 1929 and contributed to the Great Depression.  The Glass-Stegall Act served as a firewall for the economy for decades.  While on this repeal path, Clinton later signed the Commodity Futures Modernization Act, which exempted credit default swaps and other sophisticated and controversial instruments from regulation. 

We must get into the “Way Back Machine” and figure out what happened in 1999 and 2000.  Banks had long wanted to get back into the brokerage business to boost profits but had never been able to convince Congress to repeal the Glass-Stegall Act.  But in 1999, President Clinton was at the height of his famous scandal and facing impeachment.  In this weakened state, he signed bills that loosened the regulation of banks, brokerage businesses, and commodities.  Under the “Modernization” banner, some futures and derivative transactions are now less regulated and exempt from supervision.  Derivative transactions between “sophisticated parties” became unregulated.  This opened the door for what we saw in 2008 and prompted the Dodd-Frank Act, reversing much of the damage from the 2000 Clinton-era act.  But typical for Congress, they enabled the problems that led to the 2008 meltdown, blamed others, and then claimed victory as they cleaned up their mess.  These two actions to relax regulations opened the door to many of the ills we see today in the economy.

Today’s Problems

If the Financial Services Modernization Act contributed to the market risk problems, and the Dodd-Frank Act reversed those issues, where is the problem today?  In our research, we discovered a lot of discussions about the “quadrillion-dollar problem.”  These range from fear of a quadrillion-dollar national debt to a worldwide depression to our topic here in the hidden derivatives world to unidentified FOREX transactions.  Are any of these problems real, or are they just people selling a product through fear?

National Debt

A quadrillion-dollar national debt seems unlikely, even with the current gross mismanagement of our national finances in Washington.  This fear has now circulated for over a decade, and while our national debt is a problem, a quadrillion-dollar national debt would take almost a century to accumulate.  Additional steps can be taken to avoid this problem, such as raising taxes.

Derivatives

Derivatives have been around forever as futures contracts for things like agricultural products.  However, they expanded to include attempts to mitigate risk in various ways over time.  Today, derivatives are used for equities, credit, interest rates, crypto, and commodities.  As Warren Buffett noted, they can be destructive in many ways and lead to market disruptions like in 2008.  It is this unsound belief that you are mitigating risk through derivatives that can lead to destructive behavior by firms with enormous volumes. 

Introducing technology into the process only enhances the possibility of bad actors causing great harm to our markets, as in 2008 with an instrument called a Credit Default Swap.  Warren Buffett is correct, and unfortunately, it will be proven repeatedly.  This financial tool intended to mitigate risk has now become the risk.  Back in 2008, some believed the amount of credit derivatives to be as high as $1.14 quadrillion, with about half of that in unidentifiable over-the-counter transactions.

The problems with derivatives from a global perspective are the complexity, volume and speed of transactions, lack of reserves, lack of supervision and oversight, and lack of transparency.  Unsavory characters know this and use this market to create both incredible wealth for themselves and significant risk for the overall market.  2008 should serve as a warning to us all.

Of particular concern seems to be the introduction of crypto derivatives.  Saying you have regulatory control over an asset that by design is untraceable is a fool’s errand.  It is too late when the supervisory agencies know there is a problem.  Crypto derivatives carry another undiscussed risk, and that is the type of contract used.  Other derivatives carry a settlement or contract date, but not always in the crypto world.  A particular type of crypto contract known as “perpetuals” has no expiration date in the crypto world.  Like other derivatives, perpetuals can be leveraged, adding to the risk.

If there is a quadrillion-dollar problem, one of the most severe risks is derivatives and the unregulated portion of that market that allows bad actors to misbehave and good actors to make bad decisions.  This risk is unquantifiable from anything we can read, and it can potentially disrupt our world just as it did in 2008 or worse.  Every attempt to regulate this part of the financial system only results in more products with greater complexity and delayed oversight.  On any given day, it is believed that the size of this market exceeds all world financial assets, so that a fractional disruption can be catastrophic.  Any entanglement between derivatives and commercial real estate, home mortgages, consumer debt, or credit card debt will be particularly disruptive in 2024 and 2025.

Foreign Exchange Transactions (FOREX)

Foreign Exchange Transactions began with the end of World War II and the Bretton Woods agreement in 1944.  But it was not until 1971, when we dropped the gold standard, that speculation in the dollar exchange rate made sense.  Here, there is also room for issues since the FOREX markets transact $5.3 trillion every day, and it is believed that the total market worth is $1.9 quadrillion.  To put this in perspective, the global FOREX market is more than twice the value of the world’s gross domestic product.

The Bank for International Settlements has warned several times that this is one of the world’s great financial unknowns and, therefore, one of the significant risks.  But this group works behind the scenes to digitize all currencies and assets.  If you want to worry about something, worry about the BIS and their quiet, behind-the-scenes moves to digitize all worldwide finance.  Their moves are strangely Orwellian and operate in a world few see or understand. 

The BIS’s insistence on the systemic risk of FOREX may be political justification for revamping FOREX with no reserve currency at its heart.  This can be done by electronically settling all transactions between countries with one, multiple, or no reserve currency.  They are also closely aligned with countries working to dethrone the dollar as the world’s reserve currency, and it would be a certainty that our Congress has little to no understanding of their actions.  I believe this is our second most worrisome issue with world finance.  We must study more to understand if the BIS is creating a FORTEX crisis so that they can come to the rescue with their technology and what role AI will play in their solutions. 

Stick to What You Know

I was advised years ago that if I could not spell, understand, or explain it, I did not need to own any of it.  This aligns with Warren Buffett’s warnings, and I still believe it to be sound advice for crypto and derivatives.  There are still plenty of places to make money that do not include excessive, unquantifiable risks.

We live in an increasingly unsettled world where trillions of dollars change hands daily and at the speed of light.  Many of these transactions are out of sight, minimally regulated, and should concern us all.  Foreign governments and central banks are massing gold reserves for a reason.  We learned some painful lessons in 2008 and found some partial solutions, but we only scratched the surface of what needs to happen with regulating the financial system.

We are never returning to the gold standard, but gold is never worth zero.  These central banks are swapping something they know to be of uncertain value, fiat currencies, for something with some residual value.

What to do?

For all of us, this is an individual question that can only be answered in ways that fit our circumstances.  The volume and size of daily speculative transactions are beyond our control or understanding.  We can understand that we need to elect people to Washington who are principled, fiscally responsible, and patriotic.  Vote wisely in 2024 as if the freedoms you enjoy depend on it because they do.  As our financial system goes, so will our nation and freedoms.