The Swiss That Broke the Camel’s Back
by Will Lehrer, Perpetual Assets
This is it. The hammer has fallen, the line in the sand is breached, and the camel’s back is fractured. The foundation of the financial house of cards just gave it’s first tremor. The move by the Swiss National Bank (SNB) to unpeg the franc from the euro will go down in history as the first shot in this war. The likelihood that a derivatives time bomb has been lit is near certain. Currency market moves are often the most sensitive, the most deeply tied into the interwoven system of financial ‘trading’.
Interest rate swaps, which are prevalent in the currency markets, are the largest pool of derivative leverage in the markets. These markets have literally trillions of dollars in daily turnover – source BIS. The leverage on top of these massive trades is even bigger. Most currency exchange (FX) trading accounts have 10 to 1 leverage, often 50 to 1! Currency moves are typically expressed in basis points, hundredths of a percent. When the SNB removed the franc’s peg to the euro, the currency moved about 30%. This is unprecedented.
It’s no secret that the financial world is interconnected. When there are massive disruptions in one small area, they can trigger a shakedown of the entire system- think sub-prime mortgage market in 2008. The trigger of derivative losses in sub-prime loans almost took down the system. One of the largest investment banks of the time, Lehmann Brothers took the fall, and the rest of the financial system needed a trillion dollar bailout.
A decade earlier in 1997, mimicking the events of last week, the central bank of Thailand unpegged the Thai baht from the US dollar. The event spread into the Asian Contagion. Southeast Asian economies collapsed. Russia went into a bond default, which caused the collapse of a large US hedge fund, Long Term Capital Management (LCTM), whose losses were $3.6 billion, for which Greenspan arranged a bailout.
Unlike the famed US taxpayer bailout of the banks in 2008, Greenspan convinced the largest banks to buy LTCM outright, and stop the bleeding. Although the US treasury didn’t stroke the check, a bailout was necessary to keep the system afloat. Per the maestro himself, had the bailout not been arranged the world economy could have collapsed.
“Had the failure of LTCM triggered the seizing up of markets, substantial damage could have been inflicted on many market participants, including some not directly involved with the firm, and could have potentially impaired the economies of many nations, including our own.”
~FRB Testimony, 10/1/1998
The Thai unpeg occurred in 1997. The global financial system was much healthier then. Confidence was high, participation was great, leverage was lower. The Thai baht was also a very thinly traded currency, whereas the Swiss franc is one of the heaviest traded currencies in the world today. The implications of the Swiss unpeg are incredible, the losses will be paramount. The damage done to interest rate swap derivatives is not even known yet. Stay tuned as the victims should surface soon. Look for big name banks and big numbers.