Thursday, 26 May 2011

Concentration, Manipulation and Margin Calls

Over the past 25 years the financial markets of the world have become highly concentrated in the intermediation of a handful of firms, and regulation has been harmonised in the interests of these few firms. As Adam Smith - that great proponent of free markets - cogently observed:

“People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices.”

Sadly, these few global firms have been for some time in "a conspiracy against the public", and have subverted the organs of public governance and the infrastructure of the financial markets to their purposes. Regulators and legislatures have done what they were asked to do in rubber stamping the policies that promoted further concentration, assured the whole time that it would result in "efficient markets", when the reality has been entirely otherwise. Exchanges were demutualised, and their new owners installed electronic trading systems to a common design, with provision for co-located HFT servers right next to the exchange's boxes to better front run their client orders. Clearinghouses were demutualised, and their new owners installed common margin algorithms and collateral rules that created a liquidity bias in their favour, reinforcing their control of global liquidity. Regulators liberalised over-the-counter markets, off-exchange trading and shadow banking so that the real trade flows that drive global markets occur well out of sight or supervision.

Four global banks are intermediaries in 85 percent of OTC derivatives transactions. The same banks dominate prime brokerage. The same banks own large equity interests in the now demutualised exchanges, clearinghouses and even warehouses of the global markets. Naturally, the same banks dominated underwriting of securitised assets. The implications have scarcely been grasped of what this portends in terms of the information asymmetries and the opportunity to manipulate markets without risk.

Each of these roles gives these few banks a view into the positions of market investors. They know who owns what, using what leverage, under what terms, and trading in which markets. Knowing that, the manipulation of prices to impoverish investors and enrich the ruling banks is child's play with a bit of ill-transparent HFT through proprietary dealing desks and connected hedge funds aligned with the firms.

These banks will protest that there are Chinese walls between their trading desks and the market infrastructure they own. The problem with Chinese walls is that they have chinks in them. (Apologies to PC crowd, but it is an old Wall Street joke I'm quoting.) We have seen from what is now reported about securitisations, that these banks structured products to trade against their clients, often colluding with hedge funds to share the profits. Is it likely that when they balance the public interest in market integrity against next year's bonus they become much more altruistic?

In October 2008 the global financial markets crashed. The story in the media is that it was a panic caused by the insolvency of Lehman Brothers. This is not the truth - or at least not all of it. The crash actually followed a $2 trillion margin call by these four global banks on their prime brokerage clients and OTC counterparties - effectively a 30 per cent increase in required margin. It was the margin call that forced liquidation of global portfolios of all asset classes - and particularly the high quality, most liquid asset classes.

Eligible margin is defined by bilateral agreement for both prime brokerage and OTC derivatives. According to the ISDA Margin Survey for 2009, the eligible collateral at the time of the crash was predominantly US dollar cash, euro cash and US Treasury securities.

Bilateral agreements are not made public, and neither are the margin calls. This is why the $2 trillion dollar margin call did not make the news. Each prime brokerge client and each OTC counterparty dealt with their margin call as a bilateral obligation, despite it being systemically the most important event in the history of financial markets.

As the markets crashed, the US Congress was threatened with chaos and martial law if it did not pass the Paulson Plan to grant $700 billion to Wall Street banks without any formal process or review. The Federal Reserve in parallel innovated a series of secret, extra-legal measures to give money to the same banks in exchange for assets which would never be disclosed, publicly valued or audited. The need to raise dollar liquidity globally to meet margin calls in US dollar led to the innovation of central bank dollar swaps - to preferred central banks only, of course.

After all the global liquidity had been sucked into the hands of these few global banks, and the dollar surged to strength along with US Treasuries, the game of increasing leverage started all over. The firms sitting on all the margin cash and global liquidity bought up all the quality assets lying about the crashed global markets at deep discount, then they started lending again. They have been reporting huge profits consistently ever since as their clients and counterparties take the assets and exposures in this "recovery" on terms very profitable to those running the markets and liqudity business.

And remember, these few firms see all your positions and know all your clearing balances better than you can. And they chair all the margin committees at all your clearinghouses and exchanges too. And they even own the warehouses where you believe your gold, silver and other hedges against financial chaos are supposed to be stored.

We are now nearing the same global levels of leverage as prevailed in summer 2008. The political situations in the US and in Europe are unstable, and China is slowing. There is money to be made in instability.

It isn't the leverage that causes a crisis, but the margin call.

In the past few months we have seen a pattern of increased margin calls in exchange traded derivatives. It makes me wonder what is happening unseen in the OTC markets. The dollar is strengthening from its lows, indicating flows back to US counterparties. Perhaps another round in the game of liquidity manipulation has begun.

Leaving that aside, how would Adam Smith recommend that we protect ourselves from the well-entrenched tyranny of a global elite of manipulators? The only resilient solution is local, transparent markets with disintermediation of the controlling banks. Eliminating the information asymetries which allow them to see everyone's positions, leverage and trading activity - and trade and ration liquidity accordingly - would go a long way to preventing further concentration.

How to do this? Would the co-opted regulators allow markets that disintermediated reliable paymasters? Those are the questions we will grapple with after the next crash I suppose.

A timely example of the public spirit of exchange executives:
SEC -- Antonia Chion, Associate Director of the SEC’s Division of Enforcement, added, “Johnson brazenly stole nonpublic information from NASDAQ and its listed companies in breach of his duties of confidentiality to his employer and clients. Johnson assured at least one corporate official that she could share material nonpublic information with him because he was obligated as a NASDAQ employee to hold such information in confidence, and then he illegally traded on it.”


Jonathan said...

After all the empty words that were spoken about reform after the last crash, I only wish I was that optimistic.

Edwardo said...

"It isn't the leverage that causes a crisis, but the margin call."

This is, strictly speaking, true. But the margin call is the inevitable night that follows the day where the relevant parties feverishly toiled to create excessive leverage.

Nassim said...

A succinct explanation of how the machine really works.

PeterJB said...

Hello @ LB

'No winners, all losers' - good to see the strength of the upper lip.


"The conclusion therefore is that there is not and never has been anything wrong with the banking sector. Unfortunately, for them they did exactly what was expected of them without understanding of the long-term consequences of their actions. The reliance of the State on the banking sector is the main reason why the State cannot allow any major bank to fail. The State needs the banks to get rid of the cash that it is printing and it also needs the banks to collect the interest on the money that it is lending to them. The State needs the banks much more than the banks need the State. Without the banking sector to launder all this newly created money the British economy would have collapsed a long time ago. The only question is how long can the cycle continue. If the UK loses its AAA status then the British Government will have to print 20% more money every year."

Here is where it is wrong: "The end is always sudden and very unpleasant and accompanied by a dramatic drop in the standard of living for the whole population."

Should read, 'the whole population except for selected "leadership" and their advisors'.

Good to see that you are still attentive LB

PeterJB said...

@ LB

"Four global banks are intermediaries in 85 percent of OTC derivatives transactions. The same banks dominate prime brokerage. The same banks own large equity interests in the now demutualised exchanges, clearinghouses and even warehouses of the global markets. Naturally, the same banks dominated underwriting of securitised assets. The implications have scarcely been grasped of what this portends in terms of the information asymmetries and the opportunity to manipulate markets without risk."'

Are you leaking information LB? What are you up to? You appear to know all but you retreat to naive analysis? Are you salting the mine LB?

How do these x4 create the Margin Calls? By what Authority?

We know the game is manipulated but to carry this manipulation out - today - needs - nay, demands, Authoritative complicity.

It was Mises I believe that suggested that those that watch, intellectually, will observe the formation of tomorrows' market.

I want to know where you are coming from LB.

London Banker said...

@ Jonathan
I wouldn't call myself optimistic, but I do keep trying in my small way to reform the system - or at least offer better policy alternatives. There will come a time when these will be needed and sought.

@ Edwardo
I agree, but where it takes two to build leverage, it takes only one to make a margin call. And it is the timing and coordination of that margin call with other market events that creates a huge profit advantage for the insider firms.

@ Nassim
Many thanks. We need a new machine - or several new machines - if we are to get better results.

@ PeterJB
I tire of your attacks on Britain. The problem we confront is global. Australia too will implode suddenly and unpleasantly when its massive debt, property and commodities bubble bursts. It is the mechanism of debt, leverage and collapse which should be our common enemy. Taking pleasure in Britain's difficulties will not make Australia a more comfortable place to live when it too sees its public and private finances destroyed by the same forces.

Anonymous said...

A coordinated $2 trillion margin call by four big banks? Yeah, that definitely didn't happen. Not surprising that you don't cite any source for that bizarre claim. Customers were still pulling funds from their PB accounts in October 2008, not the other way around.

Honestly, where do you come up with this stuff?

PeterJB said...

@ LB

" I tire of your attacks on Britain."

You obviously misinterpret my comments where I totally agree with your statement:

"Leaving that aside, how would Adam Smith recommend that we protect ourselves from the well-entrenched tyranny of a global elite of manipulators?"

But the question is not what Adam Smith would recommend, but that which you LB, as the London Banker and resident London Banker would have us do.

I do not attack Britain at all, after all, I am a colonial servant.

But what I will not stop is pointing out of the incompetences, ignorance and criminal behaviours of those who as "leadership" with the trust of their own peoples, gullible indeed, so easily betray and condone wealth transfer, or theft, and as well actively participate in same to the detriment of their own Nation, which includes killing or having killed its own citizens.

I am well aware of Australia's current good luck by being found in a temporary void.

No pleasure taken at all, au contraire.

But I do call on you to utilize your position and status, to speak out, as Merv King has done, as so many peoples of the streets are now speaking out, as Ron Paul is speaking out in an attempt to convince those of "leadership" not to so easily stress the relationships between all human beings into a state of war between "us & them" and thus causing genocide, death, human and tragic loss and sadness.

It is not only Bankers and their assets that need to be secretly consulted in these times, but the peoples also need to be consulted in a serious encounter where diplomacy focuses on humane and civilized outcomes which benefits all - Why should the peoples pay for the losses of Government protected Banks?

That is to say, the final default position for "leadership" is to "KILL" its own subjects, a priori, in order to retain their paradigm that they are right in all matters, that they are above the Law, that they Rule by Divine Right and that everybody else is wrong and expendable.

My argument is that they just do not have the intellectual capacity to satisfy the requirements of the station / position - so they should step down and make way. Not so easy - and hence the problem.

So I give you some stimulus, for in your position as a London Banker, you obviously have influence and a wide network; use it; my message is for you to use it - and not just only to write some anomalous articles which would hardly create a mild breeze; it is time LB for you to stand up. You will find freedom in the height of battle (Clausowitz) which I guarantee to you, is true.

After all, you are a London Banker - a position equal to that of the Gods.

kcb said...

interesting discussion and perspective.

smaller point: having worried over the use of this expression in the past and having looked up its derivation, i believe "chinks" means "narrow opening" such as a fissure or crack.

Anonymous said...

London Banker, great to see that you have penned a new post. For your loyal fans, at least this loyal fan, a selfish question; what might we expect in the way of frequency of your most excellent contributions?

And this, a companion article posted recently at the ZeroHedge blog:

EU - A Flawed Foundation, But Brilliant Strategy?

11k said...

Thank you for writing this up LB. You have done one honorable part in letting people know the deceptions and crimes behind. I wish there is more you could and would do given your expertise.

Your Bagehot 1873 quotation seem at odds with both what you are nobly trying to do and what modern London bankers are like.

London Banker said...

@ PeterJB, Anon 18:40 and 11k:

I have a career beyond the blogosphere. This takes precedence. I would rather reform the real world than change a few minds on the web.

I try to live my values. I believe the projects I have undertaken since the financial crisis broke in 2008 would improve capital markets in the public interest. Sometimes my preferred reforms will be premature, as many still desperately want to believe that what they learned on their MBAs and economics courses still has relevance despite the obvious market and regulatory failures. There will come a time when the market failure is too severe to explain away as random black swans or exogenous variables. Then those of us who have been consistent in our principles and put in the effort to craft and document relevant solutions will be sought and will be valued. At least I hope so!

Misthos said...

LB, I believe you once said that gold bugs were mad. What is your view today? I think that as the system eventually breaks down, gold will once again assume a role in international trade and finance. It can be argued that the process has already underway with central banks being net buyers of gold.

PeterJB said...

@ LB

Thank you for your comment which compelled me to re-read your article which, I believe, as been added to through some quiet editing.

I believe what you are saying is becoming somewhat far more specific than that which you initially penned?

In fact, I am now somewhat gob-smacked to see what you have unearthed or better, exposed - well done.

The inference which I read now is that the margin calls - where intentional, calculated, premeditated and Authorized by ... Federal Reserve? Bank of England?

But help me a little more please, as some of the big TBTF were not Banks until after Paulson had done his thing, could you care to name the x4 Banks in question?

I will understand if you prefer not to - but this article of yours, I believe has legs...

Collusion to wrought global havoc methinks is criminal beyond contempt - at the highest levels.

Sensational. Dump the collateralized toxic waste assets onto the people and take their cash - proof that the bailouts were far more than double as stated.

I believe that this allegation suggests that members of government and the FedRes have lied more than once under oath.

The implication have always been there but this cuts far, far deeper LB.

As I asked: what are you doing? And, as you have gone this far, why not go the full hog and quietly get out of town - in haste?

Anonymous said...

How expansive is your view?

If you google Wesley Clark, 5 star general who was in US Presidential race, you will see a position paper written in 2003-4. It is wide ranging, discussing impending military actions into Iraq (and I think we were in Afghanistan at that point), haven't time-lined it.

Near the bottom of the paper, he discusses *currency wars*. The primary objective of the physical wars was discussed in terms of control of oil (and presumably, oil denominated in USD).

Let's think back. 9-11 gave pretext for going after the "enemy" no matter what direct association he/they did or did not have. So, here in 2011, we are there. Mr. Clark discusses recently, the goal of controlling 7 mid-east countries. They are destabilizing as we speak and our responses are mixed, to say the least. So let's say we have a military strategy for USD/oil (in the name of "security).

Would we not also have a currency strategy? Would there not be so called collateral damage in that the US and global populations might suffer the consequences as a result of all of the multitudes of blind eyes that apparently exist? That the Euro, which was at one point a formidable threat to USD/oil might not also need to be destabilized (as it is)?

That all this might look like an overwhelmingly complex problem that cannot be pinpointed and resolved, with an excess of plausible deniability and confusion? There is not ONE EFFORT to authentically reinstate transparency or controls against manipulation?

When you can produce and gather up all the money in the world, and the property, rigging the game, is it not an ultimate form of power? If you consider that at least 1/3 of the world's total money circulation is filtered through offshore entities which are also blind, unregulated and undocumented (TREASURE ISLANDS, Nicholas Shaxson), indeed, a GLOBAL issue, as London Banker says, one must ask how high the strategy goes. Unfortunately, I have concluded that there is virtually no limit.

My father was friends with a very wealthy man who made his money in the 80s and early 90s in the trade business in China, importing cheap goods to the US. He taught me the game of money lender...he told his borrowers straight out without pretense - I collect houses so don't miss your payment. This man had no soft spot. He bought gold bars with his money and he had his own walk-in vault. He didn't believe in any currency but gold. Are most mega-wealthy like him? I think more than we care to think.

The truth of it was this, the game was actually more important to him than the money. The money was for his family, but the game was for him. I think the global game gives the bankers quite a thrill; and there is no soft spot for humanity, whatsoever.

11k said...

What LB writes in this article isn't everything I already know, but entirely fits my picture of the Truth. So i believe what he says is true.

LB, I wish you success and good luck in your noble pursuits. Making markets fair is a steep uphill battle, if not a wall climb! But we should still do it.

My guess of the X4 are: JPM, GS, DB and UBS. May be someone can confirm.

PeterJB said...

@ LB

After due consideration, I believe that you not only owe it to the public but you also owe it to yourself, to name the four Banks that you imply and allege to have perpetrated this global disaster for nefarious reasons, as outlined in this referenced article.

It is not enough to take kudos from wild and sensational accusations - in imitation of the Main Stream Media (MSM) - if you are a person of credibility: you must for the sake of the global situation as well as for your own integrity, name the x4 Banks and support your accusations:

Allow me to remind you what you state on your Blog:

"The name 'London Banker' had especially a charmed value. He was supposed to represent, and often did represent, a certain union of pecuniary sagacity and educated refinement which was scarcely to be found in any other part of society."

- Walter Bagehot, Lombard Street (1873)

Let us then to rejoice, that one 'London Banker' stands, albeit alone - but with friends.

PeterJB said...

@ LB

Speaking of lack of ethics, predatory activities, and such like normal banking activities du jour - I speak in the collective sense - there is an interesting article today by Charles Hugh Smith of 'oftwominds' to be found here:

Appears relevant despite the context being Greece: there the bones have not yet been picked clean.

I also would like to draw your attention to Rothbard's book: Wall Street, Banks and American Foreign Policy, which if you have read, indicates that there are really no shocking revelations to the well-read and sentient - just a proliferation of unnatural cannibalistic living dead, zombies, that need to be exposed to the light of day.

Saying that however, does not mean that the innocent, gullible and trusting are not to be protected by the able from those ghouls which feed on these unsuspecting.

Such is a responsibility of station.

eeyores enigma said...

Thanks London Banker - This is just the same 'ol same 'ol modus operandi worked out ages ago with a new Globalized high tech twist. We all periodically sit down at the board game knowing, but forgetting that the outcome is a foregone conclusion.

"I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs."
Thomas Jefferson, (Attributed)
3rd president of US (1743 - 1826)

Karen said...

It is indeed extremely unfair that those who are supposed to "mind the farm" (run things) can also be players.

Allowing a casino to employ players as well as croupiers without checking constantly for improper communications is a terrible way to keep gambling honest.

Sadly, it seems that if we wait for government to fix these problems, we'll wait a long time.

In the environment you describe, it really makes sense to avoid margin investing entirely, and to minimize trades by investing for the long term. And if you can identify opportunities for direct investment that bypass these big banks entirely, that is best of all.

PeterJB said...

All or most Governments of elected politicians today, have become superfluous as they, mostly, sell themselves to the highest bidder while the attendant bureaucrats follow suit. Nobody (I speak generally) in high office gives a moment's thought to the well-being of the general public. This is the message that is coming from observed facts and as reported in the (gasp!) MSM.

The socio-economic fabric of structure and organization built of some form of integrity and respect, is in its final stages of collapse and those that know, cower in fear in the dark - while those in hob-nailed boots and uniforms drag their neighbours out of the beds, in the dark of the night - for matters of national security, the war on terrorism and in the search of WMD. Betrayal and cringing cowardice is today's paradigm birthed out of self-instilled fear, albeit abetted by our "leadership".

"The Four Horsemen of Banking (Bank of America, JP Morgan Chase, Citigroup and Wells Fargo) own the Four Horsemen of Oil (Exxon Mobil, Royal Dutch/Shell, BP and Chevron Texaco); in tandem with Deutsche Bank, BNP, Barclays and other European old money behemoths. But their monopoly over the global economy does not end at the edge of the oil patch"

"According to company 10K filings to the SEC, the Four Horsemen of Banking are among the top ten stock holders of virtually every Fortune 500 corporation."

Indeed, while the article details new and rather disturbing particulars of the banking cartel and its incestuous tentacles, the sense is that it agrees in the details with Murray Rothbards 'Wall Street, Banks and American Foreign Policy', which has been around for some time.

Note that this is Part 1 of a 4 Part Series,

So the question begs: why the co-ordinated margin call? One answer, that is unacceptable, is that this lot want to take over the World, as they already own it.

An answer which I suggest is more appropriate, is that these who would be kings, are fallible and like most others, have seriously erred. In other words they have the wrong "Economic Theory" and together with all the care of their stealth and deception, their gun has still misfired. They have erred. They have panicked and are now desperate as they face the abyss of their own deaths - nice change..

Note: These banking families haven't been around that long and as all the others before them, they too will be thrown to the winds - as ashes from the crematorium.

Value, is of the esoteric, not of the symbol or objective thing, and as such, is not determined by the nature of those objects flaunted but through our evocations arising from vital interactions. Value is not intrinsic to the object, it is within us; it is the innate measure of the unique function of the 'Son of Man'.

Fear is that which we must face; and our only real fear.

PeterJB said...

Below we summarize the key findings of a just released discussion by the BIS on the "Expansion of central clearing" and also present a parallel report just released by BNY ConvergEx' Nicholas Colas who independetly has been having "bad dreams" about the possibility of what the transfer to an exchange would mean in terms of collateral posting (read bank cash payouts) and overall market stability, and why a multi-trillion margin call could result in the biggest buying spree in US Treasurys... Ever.

First, for those who are unfamiliar, here is what happens when an exchange (or a Central Counterparties) proceeds to trade OTC derivatives with any given counterparty (from the BIS):

PeterJB said...

Excellent article here:

Debtors’ Prison by Robert Kuttner

"History’s two great negative and positive examples of how to deal with unsustainable debt are the periods after the two world wars. At the 1919 Versailles peace conference, the creditor mentality prevailed, and Europe’s postwar recovery was aborted. Britain and France imagined they could bleed defeated Germany to pay off their own immense war debts (mostly to the United States). Britain also pursued tight money to keep its own currency valued at prewar levels, in order to protect the creditor class."

"The policy wrecked the German economy and kept British unemployment above 10 percent for two decades. "
h/t Yves smith

Knute Rife said...

@PeterJB 0235

Yes, a hard money policy has always been such an excellent tool for expanding an economy. Look at the Panic of 1873, for instance.

@PeterJB 2004

Interesting article by Smith. Although he is referring to a sovereign (more or less), the article is a nice response to all the self-righteous shrieks over "strategic defaults" we hear in the US these days. The predatory lenders get to prey all they want, but when the borrowers discover they are prey, they are to stay put like staked lambs.

Timmy said...

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Richard said...

Thanks for the informative post. I do not know if you saw it, but the European Commission has begun an inquiry into Markit. Markit is a financial information vendor owned by the largest derivative dealers. Markit's specialty is credit default swap pricing data.

It has occurred to the EC that perhaps the derivative dealers are taking advantage of their ownership in Markit to use the pricing data to their advantage.

At the same time, the Market Group is trying to organize an ABS data warehouse for the ECB. The Market Group ownership includes, surprise, several large sell-side firms that possess the same conflicts of interest as present in Markit.

It is enough to make one wonder why investors play in such a rigged game.

SEO Company said...

How to do this? Will regulators allow markets co-opted to reliable payers disintermediation? Those are the questions we will deal with after the next crisis, I guess.

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