The Next Crisis Is The Mother Of All Counter-Party Risks (Part 1)

What is counter-party risk? And how many people really are aware of the consequences of systemic counter-party risk?

Counterparty risk also know as default risk is the risk to each party of a contract that the counterparty will not live up to its contractual obligations. Counterparty risk is a risk to both parties and should be considered when evaluating a contract. In most financial contracts, counterparty risk is also known as default risk, a risk that a counter-party will not pay as obligated on a bond, derivative, insurance policy, or other contract. Financial institutions or other transaction counterparties may hedge or take out credit insurance or, particularly in the context of derivatives, require the posting of collateral. Offsetting counterparty risk is not always possible, e.g. because of temporary liquidity issues, malfunctioning of markets or longer- term systemic reasons.

In simple terms counter-party risk is when the counter-party doesn’t meet the obligations of its agreement because of its own doing or because parties of the counter-party don’t deliver or because of systemic or regulation risk. And in general counter-party is a concept referred to mostly in financial transactions though in principal it is just the failure of the other party to meet its obligations. I will explain later in the article the mother of all counter-party risks: the devaluation of the currencies. Currencies are the ultimate benchmark of (global) wealth.

Forms Of Counter-Party Risk:

1. Failing to meet contract obligations
2. Devaluation of the currency
3. Losing pensions
4. Futures that can’t deliver
5. Bail-in by banks
6. Reverse repos
7. Shares that are not certificated
8. Credit Default Swaps

Addendum 1- See above

Addendum 2 - See below

Addendum 3 - Losing Your Pension. A person who works at a pension fund did a study last year in which he concluded that, because of the extreme degree of public pension underfunding, a 10% decline in the stock market for a sustained period – i.e. more than 3 or 4 months – would cause every single public pension fund to blow up.  As he has access to better data than most, he also surmised that the degree of underfunding is 2-3x greater than is publicly acknowledged by the mainstream media (see below the difference between the expected returns and the real return policies). We have already experienced Enron as one of the most prolific examples of pension counter-party risk as a result of mismanagement. The collapse wiped out thousands of jobs, more than $60 billion in market value and more than $2 billion in pension plans. The US has tens of trillions in unfunded pension liabilities, which ultimately will have to be financed by the younger taxpayers. An aging population is cashing in on needed retirement benefits while the younger generations must support multiples that we all know are financially unsustainable. It is the dilemma of the retiree that needs clothing, food and lodging, and the bankruptcy of cities and state governments and the burden on the younger taxpayers that is the one of the makings of the “next” economic crisis.

Following the increasing shortfalls in 2014 a new Federal law made it possible for pension funds to cut benefits for their recipients. The Central State pension fund in Kansas became the first such fund to take advantage of the 2014 law as 400,000 Americans who depend on their monthly pension income to pay for such things as their mortgage, groceries and medical expenses saw an average of $1,400 per month sliced of their monthly benefits. But take a look South Carolina’s government pension plan, which covers roughly 550,000 people, one out of nine state residents, is a staggering $24.1 billion in the red. An analysis by The Post and Courier of Charleston noted recently that “Government workers and their employers have seen five hikes in their pension plan contributions since 2012, and there’s no end in sight.” (most employees now contribute 8.66% of their pay, vs. 6.5% before the changes). At the same time, the pension fund has been chasing more risky stocks and alternative investments instead of relying on stable investments like bonds that may be much less volatile but generate only meager returns. And then we should all be aware that these pension companies make these investments with equity and bond markets at peak levels! The cape Shiller index S&P500 PER is 30x whilst the median is 17x and the Market Valuation/GDP ratio (‘the Buffett ratio”) is at 1.2x. Imagine what the shortfalls in pension funding will be when the markets correct its overvaluation!

California’s Calpers public retiree system is notoriously underfunded and doomed to implode. Chicago, Detroit and other urban wastelands are sagging under abysmal debt a trend to continue and widen. Dallas, Texas pensions went insolvent. The Dallas pension fiasco could happen in your state or city too. Puerto Rico is nothing but a propped up bankruptcy. The Michigan Public School Employees Retirement System pension fund is $26.7 billion underfunded, and mind-blowingly has paid out more benefits than it has actual assets in 41 of the last 42 years, according to some estimates. The Mackinac Center for Public Policy has estimated that, as a result, more than a third of Michigan’s school payroll expenses go to retirees, not those people actually teaching children in a classroom.

Legislators are debating help for roughly 100,000 coal miners who face serious cuts in pension payments and health coverage thanks to a nearly $6 billion shortfall in the plan for the United Mine Workers of America. And the Teamsters just got permission to slash benefits by as much as 30% for some 400,000 participants because its Central States plan are so deep in the hole.

Overall it’s a very disturbing trend, and according to one organization nearly one million working and retired Americans are covered by pension plans at risk of collapse — and many more plans face shortfalls that could become equally problematic if action isn’t taken immediately. The problem is only going to get worse as payouts remain bloated (retired police officers in California receiving $100,000+ pension payouts!) and investment returns remain hard to come by (overvalued peak markets!!). With global growth minimal and the interest-rate environment still quite low by historical norms even in the face of recent Federal Reserve moves, who wants to hike interest rates another 2 or 3 times this year, the situation is quite pressing.

Next to that few people understand the consequences of the $6 trillion public pension hole that we’re all going to have to pay for. The current approach calculates pension liabilities by discounting pension funds cash flows using expected (not actual!) returns on risky plan assets. But Finance 101 says that liability discounting should be based on the riskiness of the liabilities, not on the riskiness (more speculative) of the assets. At June 30, 2015, aggregate liabilities were officially recognized at more than $5 trillion, funded by assets valued at almost $4 trillion and leaving $1 trillion — or more than 20% — unfunded. These are debts that must be paid by future taxpayers, or pensioners lose out. Taking into account benefits paid, passage of time and newly earned benefits, we estimate June 30, 2016 liabilities at $5.5 trillion and assets roughly unchanged at that same $4 trillion, indicating a $1.5 trillion updated shortfall.

Though if we take into account the cost of risk, instead of the return from high risk investments, the realistic way of calculating the real funding shortfall, and low US Treasury rates we estimate that the 2016 risk-adjusted liabilities nearly double to about $10 trillion, leaving unfunded liabilities of about $6 trillion, rather than the $1.5 trillion deficit based on expected returns a $4.5trn difference! Nothing to sneeze at.

Because today’s actuarial models assume expected returns and ignore the cost of risk, risk isn't avoided; indeed it is sought! By investing in riskier assets, pension plans’ models then enable them to claim they are better funded and keep required contributions from rising further, politically the “correct” policy. But this way of thinking and set up is asking for a disaster based on alternate motives than those that should be really applied to get secure and reliable pension payments.

This is a typical way politicians tend to mask problems that otherwise would be too unpopular to tackle for them to be re-elected. This is the essence of politics as we also witness with immigrants in Europe, especially in Sweden and Germany, keeping secret and not publish the real news that happens, the financial problems in Spain with the banks charging mortgage holders higher interest rates than legally allowed and subsequently not paying the penalties as ordered by the courts, and in the US the doubling of the total government debt to $20trn saddling the taxpayers up with future declining income. Every time it is the same story, it is the route of the least resistance at the expense of the citizens in favor of the politicians and the bankers. We basically need a kind of French Revolution to clean this up!

So we know Washington has a knack for ignoring long-term financial shortfalls and painting overly rosy scenarios about the future to make their numbers work in the here and now so that the politicians get re-elected. This pending pension crisis will leave millions of Americans without sufficient or any income in the very near future, mathematically a surety unless you dilute the hell out of the currency, which basically boils down to the same outcome in terms of strongly, reduced purchasing power. And then we haven’t even discussed the unsustainability of Social Security — which by the latest tally will see its trust fund go to zero just 17 years from now, in 2034. The looming problems with Social Security make things even more disturbing. If older Americans never bothered to build up much in the way of retirement savings then Social Security is quite literally the only way for them to make ends meet.

According to data from 2013, the average household income of someone older than 75 is $34,097 and their average expenses exceed that, at $34,382. If their benefits are cut, their spending will fall. A dramatic reduction in benefits to millions of pensioners, the failure of Social Security to bridge the gap and a substantial decline in consumer spending as a result will tank the US economy. It will be a double whammy of unimaginable proportions. Some investment experts expect as little as 4% annual returns in US equities, and bonds to yield less than 2% for many years to come. We have incurred such enormous debts, which basically means bringing and spending future income forward, that we don’t have any wiggle room left and something will have to give. Politicians with their false narratives just to ensure that they will get re-elected and maintain their power and deep state position have lead us to a disastrous situation we all are going to pay for.

America is rapidly approaching a point of no return, which will have serious effects on the American economy for decades. Going forward pensioners will get a much strongly reduced pension, already as a result of the ZIRP, if they get one at all, or pensioners will get a nominal income with strongly reduced purchasing power i.e. a much lower reel income. I think only the discipline enforced upon us with gold as the backing for pension obligations and our monetary system could possibly “rescue” all if not part of our wealth. I hope I have made clear the counter-party risk that is endangering the pensioners.

Addendum 4 - Comex Futures. When the Comex can’t deliver the physical gold and silver when asked for physical delivery because there are not enough registered inventories. This situation is in fact facilitated by the Comex which allows the bullion banks to take naked shorts and allow the bullion banks to dump futures equal to one or two years production in just a few minutes to depress gold and silver prices. And this all without any investigation from the Comex illustrating their approval and thus involvement in the gold and silver manipulation. The Comex and thus the people in control make more money when the volumes are higher and thus have less incentive to reduce the number of futures contracts traded daily. When everybody suddenly starts asking for physical delivery instead of nominal settlement in US dollar because investors lose their trust in the US dollar, the Comex won’t be able to meet its obligation to deliver the physical. 

So the only way to hold gold is through physical, physical gold is nobody’s obligation, or though gold mining shares because you become joint owner of the gold resources in the ground. If investors acquire mining shares they should ensure that they certify their shares. A stock certificate is the physical piece of paper representing ownership in a company and also holds information such as the number of shares owned, the date, an identification number, usually a corporate seal, and signatures. If you don’t certificate your shares you could win the battle and lose the war if the stockbroker or custodian goes bankrupt. Just look at the case with Jon Corzine who ran MF Global when it collapsed into bankruptcy in 2011 and lost more than $1 billion in customer money.

Addendum 5 - Bail-Ins By Banks. A bail-in is rescuing a financial institution on the brink of failure by making its creditors and depositors (which are also creditors of the bank) take a loss on their holdings. A bail-in is the opposite of a bailout, which involves the rescue of a financial institution by external parties, typically governments using taxpayers’ money.

In this context we should look at the outrageous behavior of the 20 biggest European banks that register around one in every four Euros of their profits in tax havens, an estimated total of €25bn in 2015. While tax havens account for 26% of the total profits made by the top 20 EU banks, these countries account for only 12% of the banks’ total turnover and 7% of their employees, signaling a clear discrepancy between the profits made by banks in tax havens and the level of real economic activity that they undertake in those countries. In 2015 the 20 biggest European banks made profits of €4.9bn in Luxembourg – more than they did in the UK, Sweden and Germany combined. Barclays, the fifth biggest European bank, registered €557m of its profits in Luxembourg and paid €1m in taxes in 2015 – an effective tax rate of 0.2%. Often banks do not pay any tax at all on profits booked in tax havens. European banks did not pay a single euro of tax on €383m of profit made in tax havens in 20155.

At the same time, a number of these banks are registering losses in countries where they operate. Deutsche Bank, for example, registered a loss in Germany while booking profits of €1,897m in tax havens. A large proportion of these profits are made despite the banks not employing a single person in the countries concerned. Overall, at least €628m of the European banks’ profits were made in countries where they employ nobody. In other words the banks want the taxpayers money when they screw-up. However, when profits are made they “legally”  scheme profits off by abusing tax laws to reduce their tax burden and not pay their fair share to the treasuries of the specific countries so that the management of the banks qualify for their very lucrative option or bonus schemes. You determine if this mentality and policy is fair!! These bankers are just ordinary thieves.

Anyway despite this all, with the bankers getting away with murder (check stories about pensioners in Italy), it looks like the bail-ins or bail-outs are a situation we are heading for in a world of increasing debt and higher interest rates, considering the fact that most banks are bankrupt on the basis of their fractional banking system. Just look no further than the EU’s Target2 system, which is a settlement system between the banks in Europe but basically a system whereby the European central banks cosmetically shield the southern European banks from showing their in facto bankruptcy. For example a client of Banco dei Monte Paschi wants to transfer €1m to Deutsche Bank in Germany but doesn’t have the money and thus the Banco Italiano (Italian central bank) guarantees to the German Bundesbank €1m which transfers €1m to the Deutsche Bank and the Bank of Italy now owes €1 million to Bundesbank. As a result the Banca d’Italia, Italy’s central bank, owes a record €364 billion to creditors, 22% of GDP and rising. The Banco de España, Spain’s central bank owes €328 billion to creditors, almost 30% of GDP. It is just a matter of time before this system comes crashing down. The lipstick only lasts so long! In my point of view it is what the Fed does with its reverse repos or treasury guarantees on a national scale.

Addendum 6 - Reverse Repos. I mention the reverse repos here because they play an important and often have a not well-understood role in the financial system for supplying collateral. Let’s first discuss repos. A repo is an overnight secured/collateralized loan, with the buyer, in this case the Fed, receiving treasuries as collateral to protect the Fed against default by the seller, commercial banks and other financial players. The Fed plays a leading role in the financial system by keeping cash and securities circulating among hedge funds, investment banks and other financial firms.

The repo market includes both the banking system and the shadow banking system (consisting of lending and other financial activities conducted by unregulated institutions or under unregulated conditions). The repos are the overnight collateralized borrowing and lending market that is the cornerstone of the entire financial system in a process where liquidity is withdrawn or added to the system to keep the engine going and not letting it run dry or overheating. And perhaps more importantly the repo market is considered the benchmark of confidence in the financial system.

The Fed, and not the Treasury, sets monetary policy. The Federal Open Market Committee or FOMC sets a target for the fed funds rate, after reviewing current economic data, currently between 0.75-1.00%. This federal funds rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight, on an uncollateralized basis. Reserve balances are amounts held at the Federal Reserve to maintain depository institutions' reserve requirements. Depository institutions with surplus balances in their accounts lend those balances to institutions in need of larger balances at the fed funds rate.

It is a kind of balancing act of the excesses and deficits in the depositary banking system. The interest rate that the borrowing bank pays to the lending bank to borrow the funds is negotiated between the two banks, and the weighted average of this rate across all such transactions is the federal funds effective rate. The loans are called fed funds or federal funds because they are excess reserves that commercial banks and other financial institutions deposit at one of the 12 regional Federal Reserve banks.

The Federal Reserve Bank of New York has a trading desk that manages the liquidity in the system every day. Two floors of traders and analysts monitor interest rates all day.  For the first 30 minutes each morning, they adjust the level of securities and credit in banks' reserves to keep the Fed funds rate within the targeted range. By law, banks in the United States must maintain fractional reserves, most of which are kept on account at the Federal Reserve. The Fed sets a ceiling for the Fed funds rate with its discount rate. That's what the Fed charges banks that borrow directly from the Fed’s discount window. The discount window is an instrument of monetary policy that allows eligible institutions to borrow money from the Fed, the central bank of the USA, usually on a short-term basis, to meet temporary shortages of liquidity caused by internal or external disruptions. The Fed sets the discount rate higher than the Fed funds rate discouraging banks to borrow from the Fed since it prefers banks to borrow from each other. The discount rate sets an upper limit on the Fed funds rate.

As mentioned the federal funds rate is the target short-term rate for monetary policy of the Fed and the Fed uses the repo market to manage, to regulate the fed funds rate. As mentioned, the Fed uses the repo market to drain and add cash to keep the fed funds rate near its target rate now set at between 0.75%-1.00%. In other words it is providing or withdrawing liquidity from the market using collateral (treasuries) to regulate the fed funds rates. Whilst the fed funds rate is the interest rate that banks charge each other for overnight non-collateralized loans the repo rate for treasury collateral (General Collateral or GC) should always trade a couple of basis points below fed funds because the GC Repo is collateralized by a U.S. Treasury security instead of a Fed’s promise but it doesn’t!!

In normal times there is no need for collateral and the Fed Funds (loans between banks or credit institutions) are considered to have virtually no counter party risk, no collateral needed. Though when we get to quarter end and balance sheets need to be synched or when the system is under pressure the demand for collateral or treasuries increases with rates going lower. It is important to make a difference here between loans with and without collateral. When a loan as in the case with reverse repos has collateral the party in possession of the collateral has virtually now risk and when stress in the system increases demand for collateral will increase thereby reducing the yield on the treasury or negative repo rates. When a loan doesn’t have collateral, like with the Fed Funds or Libor, and there is thus no recourse for the lender the interest rates will spike because that will be the only way the lender can hedge its risk and because those loans are considered to be worth less than face value dependent on the level of risk. This is what we saw in 2008 when Libor went through the roof whilst the repo rate tanked to -500bp or -5% compared to the fed funds rate. So having collateral or not is the difference between rates plunging or going through the roof showing the risk, tension rising in the system.

And thus GC is considered more secure than Fed Funds because it is a worldwide accepted collateral guaranteed by the Treasury of the US that is considered not to have counter-party risk. Remember the Federal Reserve, which is different from the Treasury, is an independent financial institution with a private/public structure and formed within the United States, that works separately from the executive or judicial branches of government and whereby the 12 operating Reserve Banks are required by law to transfer net earnings to the U.S. Treasury.

As discussed there is a general trend in the relationship between the two markets, the repo and fed fund market, but over time the spread of their rates can vary wildly, especially at quarter ends and times of stress, as shown by the chart here above. GC (general or treasury collateral) or repo rates have traded anywhere from 25 basis points above fed funds (the “normal” situation) to 500 basis points below fed funds over recent years when there were extraordinary circumstances because at those times banks are even not secure, as we have seen with Bear Stearns, and counter-parties want to have the best collateral they can get: Treasuries. The spread between GC and Fed Funds tells a lot about the financial markets at any given time. It’s a good indication of what’s going on behind the scenes as is particularly shown when the statutory capital reserves need to be synched. Though in my point of view the need to synch the capital requirements only at quarter-end because of the reporting requirements is kind of a farce. What about the capital requirements in the time in between? What good is it if banks only synch or ensure their capital requirements at these specific dates?  Remember Lehman transferring $50bn in debt to London just before year-end to “clean up” its balance sheet temporarily?

As mentioned at times, the spread or the amount of reverse repos (and need for collateral) show when there’s stress in the market and when market participants are over-leveraged or underwater. When you want to keep the rates at a constant levels you have to be prepared to supply unlimited collateral when needed as we can see in the chart below, courtesy of the St Louis Fed (or the so-called Fred). We see that the amount of reverse repos or demand for collateral is trending higher and higher. Since 2009 the treasury collateral has been increasing from $100bn to a peak level of $650bn at the end of 2015 and is now at $500bn. As the St Louis Fed chart here below shows since the beginning of 2014 the “demand” for reverse repos treasury collateral has been trending higher from the $200bn level. In 2008 the reverse repos only reached $100bn and that is when the financial system was only a couple of days from financial Armageddon.

So the question is what is happening behind the scenes that we don’t know about and apparently is demanding hundred’s of billions of collateral in the form of treasuries. The Fed keeps the repos rates in check or kind of fixed as we discussed here above in order to regulate the fed funds rate and thus the stress will express itself more in my point of view in the outstanding amount of reverse repos (collateral) than the price level. In other words a fixed price doesn’t imply or show us the level of risk anymore and therefore the free market mechanism should considered to be broken. For me it kind of reminds me of the situation in the gold futures market with the issuance of gold futures by the bullion banks when the gold prices are expected to rise “too much” and the bullion banks manage the price rise into a price decline.

Under these circumstances the bullion banks increase the number of contracts, in other words they go short taking the other side of the futures contracts, when more investors enter the futures market to go long. Increasing funds and a constant number of futures would drive the futures price of gold up (increased demand whilst same supply) strongly and in order to prevent that the bullion banks just issue new contracts, whereby the bullion banks take the short end (hence why they need to push the price ultimately lower to prevent losses and I even haven’t highlighted their criminal way of hedging in the opaque unregulated and not standardized OTC market). By issuing new futures contracts they dilute the amount of money that is flowing into the gold futures market. As a result the price for gold rises less and less leading to a slowing momentum whilst at the same time the open interest (the total outstanding contracts) is increased significantly, which in a normal rising market should show a strong price rise. Subsequently because the buyers (funds) of long gold futures contracts get exhausted and disillusioned the gold price will rollover and the bullion banks will drive the price lower by dumping a lot of futures contracts in the markets pushing it through stop loss levels, known to them from their clients (conflict of interest!), thereby accelerating the downward price movement. And as a result the bullion banks will make a handsome profit and the non-bullion bank investors will in general incur losses time after time after time. So much for making people believe that this is a free market and that the low gold prices signal no stress in the financial system (the opposite is true, everything is fake). These in-transparent operations are sophisticated crimes that hardly anybody understands and thus as a result there is no outcry and hence none of these criminals go to prison.

See in the chart below how much short the commercial had to go to keep the silver price below the important technical level of $18.50/oz. Though the moment investors en masse will demand physical delivery (because of a tanking dollar, another credibility issue or because the physical is regarded such a bargain) the ball game will be over because there is not enough gold or silver in the registered inventories (allocated for delivery on futures expiration) to meet demand. As we know the paper futures to physical (in inventory) ratio ranges between 90x-500x:1.

In my point of view we see the same mechanism happening with the reverse repos where repo rates are kind of fixed except for at quarter ends, and thus give a false impression of no tension in the system whilst at the same time we have seen the amount of collateral increasing dramatically as pointed out. In other words reverse repos are next to managing the Fed Funds rate also used to support the financial markets with treasury collateral when needed, especially when financial players are underwater and in need of collateral in order to avoid a systemic domino effect and subsequent breakdown of the financial system. And with that exercise the Fed just creates the misleading idea, as it does in the financial markets, that everything is hunky dory, which of course is not the case! Just look at all the economic statistics that are totally fake! The Atlanta Fed model forecast for real GDP growth (seasonally adjusted annual rate) in the first quarter of 2017 was just downgraded from 1.2% to 0.9% on March 15. The forecast 0.9% GDP would mark the weakest quarter since 1987 in which rates were raised, according to Julian Emanuel at UBS. And thus it is impossible that the unemployment rate is 4.7% as Obama wanted everybody to believe. It is more likely to be in excess of 20% (see the U6 nr at shadowstats.com) next to that and even not seen in 2008, the number of vacant stores in NYC, the beacon of resilience, is quite in your face and telling us something. Second hand car sales prices are dropping significantly and the flipping of condos in Miami has taken a turn for the worse. The main question is not if but when Wall Street or Fake Street will be closing the gap with Main Street. This will only happen when we have an event that rocks the confidence in the financial system.

After all boosting the amount of collateral in the market to prevent higher repo rates can only continue for so long and when these illusion creating manipulations fail the end result will be quite ugly with a lot of wealth destruction. In my opinion we can detect similar behavior of mitigating the price effects as we witness with the repo rates and gold futures with the Vix, the GDX and the GDXJ. All these markets are manipulated. When the breakdown happens I strongly believe the Fed will try to resuscitate the markets with a huge stimulus package, severely undermining the US dollar, and which might work for a couple of weeks or months but ultimately won’t succeed because investors will have lost confidence. And I strongly believe that the second sell-off will be even more brutal because confidence, which is a very precious thing, can’t be restored when it is broken and therefore the correction will have to run its course.

According to Liberty Street Economics, the size of the fed funds market was $200 billion in 2007 and was down to only $60 billion in 2012. The repo market, by contrast, was as large as $7 trillion in 2007 and is estimated to be around $3.5 trillion today. It seems like the repo market is the (overnight, very short duration) market for the entire financial system, as opposed to just the declining inter-bank fed funds market.

Following the domino effect that evolved in the market following the 2008 recession the financial authorities are looking to shore up the buffer in case of calamities. As a result the estimated tab needed for backstopping the short-term lending repurchase agreements has now risen to from $50bn to $73.84bn, according to a filing this month by Depository Trust & Clearing Corp. (DTCC). The DTCC operates the clearinghouse that facilitates trading in the repo market and is a firm owned by banks and trading firms and is a key part of Wall Street’s plumbing. The total of $73.84bn reflects an amount DTCC will seek in commitments from member firms to cover the cost of a special credit facility. That facility can be invoked if a member defaults and the clearinghouse’s other resources become exhausted, forcing its Fixed Income Clearing Corp. subsidiary to step into the shoes of the defaulting firm and assume its financial obligations.

The proposal to set up a special credit facility is the latest iteration of suggested fixes to the repo market, which has come under scrutiny from traders and policy makers since the 2008 crisis for a tendency toward illiquidity and fragility at times of market stress. The increased estimate reflects more activity in the $3.5 trillion U.S. repo market making its way into Fixed Income Clearing Corp. that processes some of the trades, as well as moves by that unit to expand its repo-clearing business.

Anyway the reverse repo market really indicates the stress in the system and because the Fed “controls” or fixes the repo rates the crucial element we therefor have to look at to measure the real stress level in the financial system is the amount of collateral or the amount of reverse repos that is being supplied by the Fed to avoid systemic risk. It shows us the potential counter party risk in the system and the $73.84bn will just a drop in the bucket in the $3.5trn repo market when things are coming unglued! Don’t trust politicians or monetary authorities they will say anything to “rescue” the system or prolong the status quo because there is no other option. Follow your gut and look after yourself and friends and family.

Addendum 7 - Shares That Are Not Certificated. Many investors don’t understand exactly how their shares are held and what the risks to their account are if the worst happens. Brokers and custodians often don’t bother to explain this situation to their clients for ominous reasons. I should explain why nominee accounts and segregation don’t always protect you from all risks.

There are four main ways in which an investor might hold securities, although not all of these are available in all countries:

• Certificated form. The traditional way of holding stocks. You receive a physical paper certificate confirming your ownership. Your name appears on the register of shareholders.
• Electronic form with direct registration. The direct successor to traditional certificates. There are no physical paper certificates – instead shares are in digital form, meaning that their existence is recorded by the central securities depository in the country in which the stock is listed. Your name appears on the register of shareholders (or in some countries, on a sub-register operated by the central securities depository).
• Pooled nominee accounts, also known as omnibus accounts. The shares are usually held in electronic form, but the name that appears in the records as the legal owner is a nominee company, which is usually owned by your stock broker (nominee companies are explained in more detail below). Many different investments held by clients of your stockbroker are bundled together in the name of the same nominee and the stockbroker records which client then has the rights over which shares. Stocks held in this way are referred to as being held ‘in nominee’ or ‘in street name’, depending on the country. Your name does not appear on the register of shareholders. So guess what happens when the stockbroker goes bankrupt! You don’t own anything you can you can forget about your shares and money!!!!
• Designated nominee or sole nominee accounts. It is unusual for individual investors to use this kind of account – sole nominee accounts are more commonly employed by institutions. The stocks are registered in the name of a nominee company, but they are not bundled together with other clients’ holdings. Your nominee account is used for holding your assets only. Your name does not appear on the register of shareholders.

While the certificated form was the traditional way of holding stocks, and still the only way to really secure yourself against counter party risk, pooled nominee accounts are now by far the most common. Stockbrokers prefer it because it cuts costs and makes the process more efficient. In addition, the fact that the stocks are recorded in their name means you will almost trade via them when you come to sell (in many markets you can transfer stocks out of a nominee account to another stock broker, but you will usually be charged for this!!).

Having stocks recorded in your own name at the central securities depository is uncommon in most countries and not possible or awkward in many. There are some exceptions, such as Singapore, where most local brokerage accounts require you to have your own account at the Central Depository (CDP), or the UK, where the process of having a personal account at CREST is simple, if rarely done by most investors though therefor not less needed. Unless you know otherwise, your account is almost certainly a pooled nominee one. This means that the legal owner of the shares is your stockbroker and your assets are mixed up with many other clients.

ow nominee accounts work. As discussed your shares are legally owned by a non-trading subsidiary of your stockbroker, known as a nominee company (sometimes a third-party company hired by your stock broker will be used instead of a subsidiary). However, while the nominee company is the legal owner of the shares, you are the beneficial owner, meaning that you have rights over them. Your stock broker will keep records of which client is the beneficial owner of all the shares held by the nominee company, trade your holdings according to your instructions and pass cash from the sale of your shares or from dividends on to you. Having the shares owned by a non-trading company rather than the main brokerage business means that your assets are “legally” separate from the assets and liabilities of your stock broker. The segregation between client assets and company assets is crucial. If the broker goes bust, your stocks are still your property. The creditors can’t touch them. If your investments were just assets of your stock broker and thus could be claimed by its creditors, you wouldn’t have any security at all.

So in theory, segregation ensures your investments are safe. But how much protection do segregated accounts really provide? Cases such as MF Global, in which clients in segregated accounts lost money, demonstrate that it doesn’t always work. Ask Corzine!! The more a reason to ensure as much as possible that you are the legal allocated owner.

This situation is kind of similar to allocated and non-allocated gold deposits. If your gold is not allocated in your name you don’t have the title of ownership and you are a creditor vis a vis the institution that holds your gold. Be aware because the more we go to an untenable situation the more important these issues become. Otherwise you win the battle in choosing the right asset, gold or silver, to preserve your wealth but you lose the war because as a result of the legal situation you are a creditor and not owner. So ergo conclusio: certificate your shares!!

To be continued.

© Gijsbert Groenewegen April 3, 2017

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