Wall Street’s Pending $100-Trillion-Dollar Margin Call

This corn contract has two parties to it; the seller (short side) who promises to deliver 5000 bushels of corn sometime in the future, and the buyer (long side) who promises to take delivery of 5000 bushels of corn sometime in the future.  

The corn market has natural shorts and longs. Farmers are expected to deliver corn to the market, as corporate entities such as General Mills or Cargill are expected to take delivery of corn. The CBOT futures corn market allows both farmers and food processors to manage market volatility in the corn market by offsetting these risks to speculators, city slickers like you and me should we try our luck trading corn contracts at the CBOT.

But trading corn contracts is not the purpose of this article, but used as an illustration for “notional value.” 

In the table below at step #1, at the creation of this contract for 5000 bushels of corn, corn was trading at $3.75 a bushel. That times 5000 bushels of corn and this contract created $18,750 in notional value in the corn market, even though the farmer won’t have the corn, or food processor take delivery of the corn for another six months.  

And how much money has the farmer or food processor committed to this contract at step #1? Quite possibly nothing, and until the market price of corn changes there is no flow of funds from one party to another in this contract.

There is a negative feedback loop in this contract that stabilizes the corn market. The farmer wants as high of price for his corn as he can get, but the very act of selling his corn depresses the price of corn in the market. The food processor wants corn at the lowest price possible, but the very act of buying corn increases the price of corn in the market.

Let’s look at the risk profiles for the long and short side of this contract. Potential losses on the long side are limited. Should corn go from $3.75 down to $0.00, the long can only lose $18,750 on these 5000 bushels of corn, as the potential gains for the short side of this contract are also limited to $18,750 should the price of corn collapse down to zero.

But should corn prices rise, market risks for the short side of this contract are unlimited. Hypothetically, should corn prices rise to $100 a bushel the short side will be obligated to pay $500,000 to the long side of this contract.

So, what I want my readers to understand is:

  • Short side profits from lower prices, and has unlimited market risks should market prices rise.
  • Long side profits from higher prices; and has limited market risks should market prices decline.

Now let’s return to the OTC interest rate derivatives market where interest rates, not corn are being hedged. I note something odd about hedging interest rates. While everyone benefits from lower bond yields, both the owners of a bond and its issuers, who is it that* naturally * benefits from rising interest rates and bond yields?

For instance, famers naturally benefit from higher corn prices, food processors naturally benefit from lower corn prices, so who benefits from rising bond yields? To my knowledge no one, and should there be, are they sufficient in number to take the other side of $495 trillion dollars in these OTC derivative contacts? Remember it take two parties to form one of these derivative contracts.

It’s like Popeye once said “I may not be a physicist, but I know what matters.”  

And what matters with these interest-rate derivatives is who is taking the other side of these contracts pension fund and insurance companies are hedging their risks of rising bond yields. I’ll give you a hint who I think is; the same banks who in 1999 urged the US Senate to allow them to create this market as a self-regulated operation. All the usual suspects that had to be bailed out with trillions of dollars by that same US Senate in 2008 & 09.

And why did Fed Chairman Powell last March begin “stabilizing the credit markets” by buying corporate bonds? And last summer felt the need to assure everyone that the FOMC isn’t going to run around in the bond market like an elephant? Maybe for fear of an instantaneous hundred-trillion dollar margin call on his banking system should corporate bond yields rise above a critical threshold that wasn’t far above the yield spikes seen last March in my charts.  

We are living in interesting times,  Gold and silver bullion with zero counter-party risks have never looked better than they do today.

 

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Disclosure: None.

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