Famously described as “financial weapons of mass destruction” by Warren Buffet, derivatives have posed ever-greater risks to the financial system and were largely responsible for the global financial crisis of 2008/9. I have often said I would sell 25% of stocks when the first derivatives blow-up occurrs and the remainder when the second derivative defaulted. That’s how big and real the risk has been.
One real problem in regulating derivatives is that they are traded off-the-exchanges, meaning we could not be sure how big a problem they presented. This lack of transparency made it difficult to estimate the threat. Fortunately, bank regulators rode to our rescue. As they audited bank statements, they hounded the bankers to justify every investment decision involving the use of derivatives. As a result, the value of derivatives actually employed has fallen markedly.
Going into 2008, there were about $35 TRILLION, declining to $15 TRILLION at the end of 2016 and “only” an estimated $11 TRILLION today. This is great progress! Federal auditors should be applauded, for reducing the risk of these “financial weapons of mass destruction.”
But money hates transparency, and nobody is confident how much of a problem “dark pools” are becoming. These are large pools of money that some banks, particularly offshore banks, and some offshore money managers to trade stock positions without transparency. In other words, you can buy or sell stocks and other assets, while nobody knows it. More pointedly, nobody knows how much leverage was used for each of those purchases. U.S. bank regulators have far less regulatory authority with these offshore dark pools.
Like water flows to the lowest point, money flows to the lowest point of regulation and transparency.
Stay tuned to this potential problem . . .