The vendors and proprietors of blockchain solutions have almost all traveled the private blockchain route. We, at Veritaseum, have decided to go in the opposite direction. Call it a yearing for our macro and fundamental analysis roots, but the risk of trusting untrustworthy parties is just too great. The only way to eliminate the need for tirust is to open the network to many parties. Think the power of the Internet vs the utility of an intranet. Ths is the third in a series of articles that show, hopefully wihtout a shadow or a doubt, that Veritaseum is on the true and righteous path. The previous two, for your convenience, are:
- With Wall Street Bitten by the Blockchain Bug, How Do We Admit the Truth About the Technology's Disruptive Potential?
- The Paucity of Plausible Arguments for Private Blockchains in Banking
In January of 2008, I warned (in exquisite detail) of the collapse of Bear Stearns. It was 2 months before Bear Stearns actually fell, while it was trading in the $100s and still had buy ratings and investment grade AA or better from the ratings agencies. See for yourself: Is this the Breaking of the Bear? As part of the analysis, I did a counterparty risk profile, see below:
Counterparty Risk
| In $ million | OTC Derivative credit exposure ($ million) | ||||||
| The table summarizes the counterparty credit quality of the company's exposure with respect to OTC derivatives | |||||||
| Rating(2) | Exposure | Collateral (3) | Exposure, Net of Collateral (4) | Percentage of Exposure, Net of Collateral | Total exposure a % of Total assets | Net exposure as a % of Total assets | Net exposure as a % of equity |
| AAA | 3,369 | 56 | 3,333 | 42% | 0.8% | 0.8% | 25.6% |
| AA | 6,981 | 4,939 | 2,153 | 27% | 1.8% | 0.5% | 16.6% |
| A | 3,869 | 2,230 | 1,784 | 23% | 1.0% | 0.4% | 13.7% |
| BBB | 354 | 239 | 203 | 3% | 0.1% | 0.1% | 1.6% |
| BB and lower | 1,571 | 3,162 | 322 | 4% | 0.4% | 0.1% | 2.5% |
| Non-rated | 152 | 223 | 94 | 1% | 0.0% | 0.0% | 0.7% |
| 16,296 | 10,849 | 7,889 | 100% | 4.1% | 2.0% | 60.7% | |
(1) Excluded are covered transactions structured to ensure that the market values of collateral will at all
times equal or exceed the related exposures. The net exposure for these transactions will, under all circumstances, be zero.
(2) Internal counterparty credit ratings, as assigned by the Company's Credit Department, converted to rating agency equivalents.
(3) Includes foreign exchange and forward-settling mortgage transactions) as of August 31, 2007
It didn't take much of a concentration of bad assets to through Bear off kilter once the market started moving against it. At the end of the day it was a dearth of liquidity and Bear's counterparties being afraid to touch it with a ten foot pole that did it in. What would such a scenario look like today, 8 years later? Well, look no farther than one of the biggest banks in Europe, and major counterparty to many banks considered a "trusted" party to members of unnamed blockchain consortia, etc. Let's let the numbers do the talking, shall we? These are pages taken directly out of our 20 page report written for our Blockchain MacroTech consulting clients. If you are interested in becoming a consulting client, contact me here.
This "trusted party" has a investment grade to junk ratio of 2:1. That's just about a junk bond fund - and this not only a bank that's an ongoing concern, it's one of the largest in its domiciled country. A full one quarter of its equity is junk. Don't fret, but it gets worse...
Using the bank's internal rating measures for default exposure to counterparties, 130% of its equity is exposed to medium-high to already defaulted exposure. One more time if that ran past you. 746% of its equity is exposed to medium-high to already defaulted exposure. Bad exposures outweigh good exposures by 1.3:1. This bank is heavily supported by the tens of billions of euro of the ECBs LTRO adn TLTRO (bank welfare) lending facilities, and it's still not nearly enough. It makes Bear Stearns look like a walk in the park, and it's arguably too big for the ECB to save in the event of a run, particularly once the counterparty daisychain effect is taken into consideration.
Then there's the fact that the bank of all of those hundred's of millions of euro in notional financial contract exposure. But notional value is meaningless in this context, right? Yeah, right!
The Notional Value Argument Often Used By Entities Taking Large Losses
During the last large financial reset of 2008/9, there was a heated debate over the utility of using notional values in the determination of risk and exposure of banks and financial companies. It is the Veritaseum’s contention that notional values must come into play.
The notional value of a financial agreement or security is contract value of said agreement. For instance, if one were to purchase one S&P 500 future for $2,000 at market, the market price (fair value) of said contract is $2,000. The contract controls $500,000 worth of market exposure though since the contract multiplier is 250 (250*$2,000=$500,000). Thus, the notional amount of the contract is $500,000. Many banks balk using notional amounts to convey the risk of the assets held on balance sheet because the notional amount of derivatives and similar securities/contracts are often much higher than the market or fair value. This can be seen in the example given, $2,000<$500,000.
The problems is that the notional value IS the market value if the underlying moves to the extreme. For instance, if the S&P moved upwards to the exteme (nominally, for the sake of discussion), then the holder of that future would would literally be in the money for the full face value of the contract. The market value of the contract converges with the notional value. Don’t think this can happen? Ask AIG if it could, or Man Financial. Thus, it is quite possible for notional to equal market value. If or when it does, and that value moves against you – it usually means very bad tidings. On that note…
OTC Financial Derivatives-Regulatory Trading Portfolios-contracts not included in netting agreements
FICC (fixed income, commodities and currencies) has proven to be a most volatile revenue category, and it looks to be getting worse. Despite the fact it is one of the (if not the) largest revenue categories in the global banking business, it may likely be one of the largest sources of losses as interest rate volatility spikes.
Now, think of a blockchain based trading system with this bank as a "trusted" trading partner. Assume you did not have access to this analysis. Would you really be able to trust this "trusted" partner.
These are pages taken directly out of our 20 page report written for our Blockchain & MacroTech consulting clients. If you are interested in becoming a consulting client, contact me here.