Given the regulatory climate and increasingly unpredictable, unconventional, desperate monetary policy, a crisis could be brewing in the OTC Interest Rate Derivatives market that will make the suffering we have experienced thus far seem like a hiccup.
Keynes wrote in The General Theory that it is “chiefly” the
“Dependence of the marginal efficiency of [a given stock of] capital on changes in expectation [that]renders the marginal efficiency of capital subject to the somewhat violent fluctuations which are the explanation of the Trade Cycle”
In the chapter entitled ‘Notes on the Trade Cycle’ he argues that “a more typical, and often the predominant, explanation of [crises] is… a collapse in the marginal efficiency of capital” and that “the dismay and uncertainty” which accompanies this collapse “naturally precipitates a sharp increase in liquidity preference”.
The Wall Street crash caused a decline in household wealth that resulted in the collapse in the marginal efficiency of capital which, in turn, precipitated in the sharp increase of liquidity preference, which lead to the numerous bank runs and failures that plunged people into the Great Depression. In the case of the Great Recession, falling house prices, panic in stock and sovereign bond markets as well as the questionable creditworthiness of many of the world’s largest, prominent institutions led to massive uncertainty and dismay that caused a collapse in the marginal efficiency of capital and a sharp increase in liquidity preference.
Since 2008, the global OTC interest rate derivatives market’s gross market value has declined in value whilst the notional amount outstanding for those same financial instruments has continued to steadily increase and this is reflected in the following chart.
The divergence in trends between the two valuations is a cause for concern because it implies that an ever-increasing amount of payments (due to the steadily increasing notional amount outstanding) is dependent upon an asset which is becoming increasingly worse at managing expected-risk; on the other hand, since 2012, Equity-linked contracts, Commodity contracts, Credit Default Swaps and Unallocated all have market values and notional amounts outstanding that follow the same trend – only interest rate contracts’ trends diverge (positive for notional outstanding, negative for gross market value). ForEx behaves a bit more strangely but this is to be expected since FX is undeniably linked to interest rates and monetary policy more generally.
This makes sense when we consider that there is tremendous uncertainty regarding interest rate policies, there are the on-going and expected currency wars, as well as the fact that public discourse favours increased regulation of derivatives markets (which threatens to diminish their ability to be effective instruments of expectations-management). So whilst previously we felt a fall in house-prices and severe illiquidity in mortgage-backed securities; this time, there is the possibility for a crash in the interest rate derivatives market itself as fears of increased regulation encourages more market participants to believe that these assets’ intrinsic risk-management capabilities are at threat.
What has caused the recovery to be so slow is that the change in expectations-management preferences (a significant part of which is the increased liquidity preference) is yet to be and, indeed, cannot be satisfied by money (since, in most nations, there is only one money that’s really available) as it ordinarily might have been because of agents’ unstable expectations with respect to interest rates and neither can it be satisfied by derivatives because markets are uncertain about future regulations.
However, in an analogous way to how the Great Depression was caused by sudden changes in monetary policy, actually coming down hard on derivatives under the false contention that their proliferation caused the crisis will actually deepen the current crisis and, conceivably, the Great Recession will evolve into something far worse than the Great Depression. Attempting to give some perspective, the total credit default swap (notional) outstanding was $62.2 trillion in 2007 before declining to $38.6 trillion and $30.4 trillion in 2008 and 2009, respectively.
By June-end 2014, the (notional) amount outstanding for OTC interest rate derivatives stood at around $560 trillion (2s.f). This is especially worrying when we consider that the exposure to these contracts is spread out amongst a wider variety of financial and non-financial institutions than was the case in the most recent financial crisis, that they are further linked to various industries and that there is an expectation that interest rates have to rise at some point (but no-one knows exactly by how much, when or how quickly).
Why OTC Interest Rate Derivatives?
So how can we be sure that the increased liquidity preference has expressed itself in the OTC interest rate derivatives market and not via another channel? After all, stock prices have increased significantly and stocks are also liquid, similarly there are fears of housing bubbles (not just here but in China, for example – though, admittedly, housing is not as liquid as stocks or certain commodities).
The crucial difference relates to superior expectations-management properties; that is, the sharp liquidity preference increase is better met in OTC interest rate derivatives than in stocks because, in addition to being relatively liquid (especially when compared to real estate), they also help manage the expected risk currently associated with the prevailing uncertainty of monetary policy and the regulatory climate.
Hence, clamping down on them will be especially harmful and the uncertain regulatory climate is already causing problems. Critics are already looking ahead to Basel IV (so to speak) since a primary criticism of Basel III is that it does not deal with the derivatives market adequately and the desire to bring OTC derivatives onto exchanges means that it will become more costly to manage expected risk (since the reason why most derivatives remain OTC is because exchange-trading would be more expensive); furthermore, there is a surge in support for populist political parties across Europe sees the danger of even taxing the derivatives trade as a way of ‘punishing’ bankers (there is, after all, a constant obsession in the media over how much bankers earn, how large the derivatives market is etc.) and this excessive hostility (from the public, academics, policymakers etc.), this will all obviously feedback into bankers’ expectations and their behaviour.
Compared to the Great Depression
Furthermore, in the Great Depression, when stocks crashed and liquidity preference soared (causing people to hoard cash), stocks were relatively liquid in 1929 (especially when compared to modern real estate). In fact, in our current crisis, bank-runs may not have occurred due to insured deposits but the problem is that the magnitude of change in the liquidity preference is likely to be greater from the collapse of the marginal efficiency of capital before and during the Great Recession than it was in the Great Depression since houses are relatively illiquid compared to stocks.
The greater magnitude of the liquidity preference increase would also account for why it has been such a slow recovery since the various avenues available to relieve the drastic change in expectations-management preferences (in terms of liquidity, interest rate uncertainty, quantitative easing predictions, unforeseen monetary policy announcements, expected-risk management more generally etc.) are simply insufficient in both variety and depth and because domestic trade in most countries occurs solely in their national monies (whose expectations-management properties are imposed upon the population by the Central Bank, regardless of individuals’ varying preferences).
So yes, stock market prices fell far more in 1929 than house prices did in the run-up to our modern financial crisis; however, compared to stocks (even back in 1929) houses are relatively illiquid – in fact, the very fact that there were plenty of unsold homes and that stocks in 1929 kept being sold off (helping to drive prices down) shows, qualitatively, just how much more liquid stocks are than real-estate.
Basel III concerns
This is also congruous with the fact that relevant agents may believe that Basel III’s requirements (which also, rather counter-productively, further exacerbates liquidity preference and depresses the marginal efficiency of capital – resulting in a vicious feedback loop) such as the proposed migration to exchanges, to say the least, will adversely impact their ability to manage expected risk with OTC interest rate derivatives.
If things remain the way they are, the next will occur by 2019 at the very latest but most likely before 2018 unless definitive public policy amendments occur (since Basel III was due to be fully phased in by January 1st 2018 but this was extended to 2019, with final calibrations due to be made, at the latest, by 2017) since the state of expectations has already set the markets in motion in a self-reinforcing and, ultimately, self-defeating reflexive feedback loop.
If the subprime-mortgage crisis and the financial crisis that it triggered was the landmine that left us on our backs, this is the subsequent, oncoming barrage of shrapnel. The crash(es) with respect to the OTC interest rate derivatives market itself will, on this view, spark an unprecedented, decimating contagion. However, public policy measures can still avert and/or delay this.