The Derivative Market Screams “Financial Crisis Ahead”
Investors have bought into the idea that the global financial system is fine. They are convinced that banks are safe and we won’t see a big financial crisis again. Don’t buy into this argument.
If you think the risks of a financial crisis have dissipated, you could be making a big mistake. The next financial crisis could be bigger than the last one and wipe out a lot of wealth across the board.
There’s one place investors should really pay close attention to: the derivatives market. It’s a ticking time bomb and no one seems to be talking about it.
Before going into any details, I’ll explain how derivatives work.
In simple words, derivatives are contracts between two parties over a certain asset. Here’s the thing: derivative prices move with the price of the asset that these contracts are based on. For example, if a trader buys derivatives betting that interest rates will go up and that doesn’t happen, the trader will lose money. The other party who took the opposite side of the contract will make money.
Interest-Rate Derivatives Could Cause The Next Financial Crisis
Now, back to why the derivatives market is worth looking at.
You see, at the moment, we have a lot of derivatives and they are centered around interest rates.
Some perspective: at the end of the third quarter of 2019, the top U.S. banks had derivatives with a notional value of about $147.1 trillion backed by interest rates! (Source: “Quarterly Report on Bank Trading and Derivatives Activities: Third Quarter 2019,” Office of the Comptroller of the Currency, last accessed January 27, 2020.)
Looking at this, you have to ask what’s next?
You see, looking long-term, no one really has a clue about where interest rates are going next. There’s noise from some people saying we are going to see negative interest rates, while others say that can’t happen.
Whatever the case may be, one thing you could bet is that interest-rate derivatives will be impacted.
And what would happen to the financial system if all of a sudden massive amounts of derivatives came under fire? We would see a financial crisis. You don’t even need all interest-rate derivatives to go bad, just 10% of them getting out of hand could do a lot of damage.
Next Financial Crisis Could Be Bigger Than Last One
Dear reader, I don’t want to be the bearer of bad news. Nor am I cheering on a financial crisis. When events like that happen, it’s not good for anyone, and the consequences are nothing but devastating.
However, it doesn’t mean one should become complacent.
I can’t stress this enough: interest-rate derivatives are making a case for a financial crisis being ahead. Derivatives are dangerous and they turn into a problem very quickly. For example, the 2008–2009 financial crisis escalated because of derivatives.
This time around, there are more derivatives in the financial system. It’s not just the American banks that hold so many derivatives. Others around the world own a lot of them too.
In the case of a financial crisis, you could bet that asset prices will tumble across the board.
So, it may not be a bad idea for investors to have some protection for their portfolios. Gold does a great job of storing wealth and could be a great hedge against a financial crisis.