Derivatives and the Something-for-Nothing Mindset

Loveland Ski Resort an hour up I-70 from downtown Denver logged 26 inches of snow in the past five days. We’ve had to cover patio plants the past two nights as temperatures dipped to 30. It’s bright and clear. But winter has had a hard time letting go this year.

Meanwhile in Europe, Morgan Stanley launched a lending book for European Exchange Traded Funds (ETFs) today. Here is the key to understanding financial reform currently mucking up Congress. It encapsulates everything that’s wrong with today’s capital markets.

You may think we’re overstating it. Nope. This is the Grand Unified Theory tying all manner and form of derivatives together, and illustrating how high-frequency trading fits in this puzzle.

It’s not Morgan Stanley’s fault. The bank didn’t create the rules. The story today at UK financial publisher IFA Online about the ETF launch concludes: “Morgan Stanley says by providing a constant supply of manufactured inventory, ETF borrowers can benefit from lower borrow fees than current market rates, and greater availability of ETF supply.”

Broker-dealers under existing rules use a create-to-lend process with ETFs. They borrow shares of the underlying components of an ETF, then use that inventory to create new shares of ETFs for trading. Then those new ETF shares may be lent out for shorting, because the broker-dealer can pass through liquidity from the borrow market for the underlying securities – stocks comprising the ETF – to those shorting the ETFs. Voila, instant arbitrage opportunity.

This process increases liquidity, which is good, except that a market thirsting for liquidity has a value problem, not a supply problem. Supply-growth also spawns derivatives that have no underlying assets. That’s like a single batch of residential mortgage-backed securities carved into multiple tranches of collateralized debt obligations that don’t represent the full underlying value.

It’s also what happens with our money. Member banks of the Federal Reserve may use Tier 1 and Tier 2 capital to create money on their books in what is called fractional lending. That’s derivative capital – something for nothing. Similarly, dollars issued by the Federal Reserve in support of US-government backed obligations are derivatives disconnected from either the assets of the country or its productive capability to meet and service those obligations. Just like the CDO market that collapsed in 2008.

Now add in high-frequency trading. As TheStreet.com writer Don Dion observed in August last year, “Both bona fide market makers and proprietary traders are seeking out the fastest way to hedge trades, create units and maximize ETF trading capabilities.”

ETFs are assigned a lead market maker like Morgan Stanley, which fashions the first units and delivers the underlying mix of stocks to the sponsor in exchange for them. After that, it can sell shares of the ETF to buyers and hedge with equivalent mixes of underlying shares. By balancing out these two and fashioning more ETF units, then doing these same things at high speed, trading trumps investing and arbitrage becomes the goal, rather than capital formation.

Making money on the spreads between residential mortgages and their collateralized derivatives is a form of arbitrage. Do it a bunch and make a ton of money.

When the Federal Reserve issues debt obligations for the government and then increases the supply of cash, it is arbitraging the value spread between the earlier debt-denominated dollar and the later, cheaper version. When ETF creators and investors buy and sell the ETFs and the underlying securities, it’s arbitrage.

And when all these things are happening simultaneously, nobody knows the real value of anything anymore. No ratings agency can accurately assess risk because no single instrument represents the full picture.

The Federal Reserve, according to statistics at its web site, was counterparty to primary dealers for transactions totaling $12 trillion of US Treasuries and mortgage-backed securities in 2009 alone. It also says that trading in government obligations averaged $570 billion DAILY in 2007. The Fed provides no current statistics, but by comparison, daily dollar volume in NYSE and Nasdaq stocks combined is less than $100 billion.

If we want this something-for-nothing, derivative problem to stop in the private sector, the government needs to get out of the derivatives business itself, first. The very body wanting to regulate this activity is the one fathering it all.

That’s the Grand Unified Theory of derivatives. It’s the notion of creating something from nothing. Something for nothing subsumes our society, our markets, our financial instruments, and our currency. The chief propagator of this policy is the government itself.

This should get our attention across the spectrum of interests, from Left to Right. We can’t treat symptoms like Goldman Sachs and expect the disease to disappear. We need to rip out the root, which is, frankly, the Federal Reserve Bank, the limitless source of manufactured ETF-like paper from government. That’s the cancer killing our markets and pointlessly enriching banks.