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Could One Rogue Trader Bring Down Global Financial Markets?  
(November 30, 2005)

Are world financial markets so precariously leveraged that a single rogue trader could bring down the entire global financial market? Before you scoff, consider the still-unfolding story of the rogue copper trader Liu Qibing who has saddled China with huge losses in copper futures. There is now talk that China will attempt to renege on the contracts to escape the $200 million loss.

The story reveals how leveraged financial instruments such as futures contracts and options can disrupt "real" markets in "real" commodities. The same is true for currencies, bonds and stocks. While it's easy to dismiss one rogue trader and a meagre $200 million loss, what is not so easily dimissed is the enormous, highly leveraged, massively intertwined system of derivatives of which copper futures are only a small part.
For more of the same, Martin Weiss of the Money Report says if you want to talk about derivatives, how about "$82 trillion held by US banks alone, according to the Office of the Comptroller of the Currency (OCC). Thatís the 'notional' or face amount, which overstates the problem. But itís still far too big ó 33 times more than the entire budget of the U.S. government.
As noted earlier here, these derivatives are increasingly popular "hedges" or "insurance" against risk. In other words, to protect yourself against a sudden drop in bonds, stocks, commodities or currencies you may be holding for appreciation or income, you purchase a derivative which increases in value if the asset drops.

But what happens if every trader and "black box" relies on the same exit strategy? Trading companies rely quite heavily on sophisticated financial models of risk and return which are programmed into what is known as "black boxes." Few understand the complexities of the software models, so the output is as mysterious as if the contents were completely unknown--hence the moniker "black box."

The dangers of "black box" trading was revealed in the Long-Term Capital Management crisis in 1998. The LTCM computer models kept indicating that an extreme in the market would turn around, so they kept betting on such a turnaround. As the bets went sour, they doubled down, and doubled down again; at the end, their derivatives bets almost brought down the banking system of the entire nation.

What if the "black box" trading programs can't account for what the other "black boxes" are programmed to do in the event of a financial crisis similar to the LTCM contretemps in 1998? Since all the models are highly proprietary, how can anyone safely predict that the "black box" triggers would all work in some magic way to defuse the crisis rather than exacerbate it by "rational" dumping of assets and derivatives?

We won't know, of course, until the crisis arrives, and it's too late to stop the unraveling of hundreds of trillions in derivative bets. To be blithely confident that no such crisis could ever erupt seems folly of the highest order.

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copyright © 2005 Charles Hugh Smith. All rights reserved in all media.

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