Menu Close

The looming quadrillion dollar derivatives tsunami part 2

Ellen Brown

“Lehman Brothers HQ on Bankruptcy Day” by Robert Scoble is licenced by CC BY 2.0

The Perverse Incentives Created by “Safe Harbor” in Bankruptcy

In The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences, Prof. David Skeel refutes what he calls the “Lehman myth” the widespread belief that Lehman’s collapse resulted from the decision to allow it to fail. He has blamed the 2005 safe harbor amendment to the bankruptcy law, which says that the collateral posted by any insolvent borrowers for both the repo loans and derivatives has “safe harbor” status exempting it from recovery by the bankruptcy court. When Lehman Bros appeared to be in trouble, the repo and derivatives traders all rushed to claim the collateral before it ran out, and the court had no power to stop them.

So why not repeal the amendment?

In a 2014 article titled “The Roots of Shadow Banking,” Prof. Enrico Perotti of the University of Amsterdam explained that the safe harbor exemption is a critical feature of a shadow banking system, one it needs to function.

Like traditional banks, shadow banks create credit in the form of loans backed by “demandable debt” short-term loans or deposits that can be recalled on demand. In the traditional banking system, the promise that the depositor can get his money back on demand is made credible by government-backed deposit insurance and access to central bank funding. The shadow banks needed their own variant of “demandable debt,” and they got it through the privilege of “super-priority” in bankruptcy. Perotti wrote:

“Safe harbor status grants the privilege of being excluded from mandatory stay, and basically all other restrictions. Safe harbor lenders, which at present include repos and derivative margins, can immediately repossess and resell pledged collateral.

“ This gives repos and derivatives extraordinary super-priority over all other claims, including tax and wage claims, deposits, real secured credit and insurance claims.”

The dilemma of our current banking system is that lenders won’t advance the short-term liquidity needed to fund repo loans without an ironclad guarantee; but the guarantee that makes the lender’s money safe makes the system itself very risky. When a debtor appears to be on shaky ground, there will be a predictable stampede by favoured creditors to grab the collateral, in a rush for the exits that can propel an otherwise-viable debtor into bankruptcy; and that is what happened to Lehman Brothers.

Derivatives were granted “safe harbor” because allowing them to fail was also considered a systemic risk. It could trigger the “domino effect,” taking the whole system down. The error, says Prof. Skeel, was in passage of the 2005 safe harbor amendment. But the problem with repealing it now is that we will get the domino effect, in the collapse of both the quadrillion dollar derivatives market and the more than trillion dollars traded daily in the repo market.

The Interest Rate Shock

Interest rate derivatives are particularly vulnerable in today’s high interest rate environment. From March 2022 to February 2023, the prime rate (the rate banks charge their best customers) shot up from 3.5% to 7.75%, a radical jump. Market analyst Stephanie Pomboy describes it as an “interest rate shock.” It won’t really hit the market until the variable-rate contracts reset, however $1 trillion in U.S. corporate contracts are due to reset this year with another $1 trillion next year, and another $1 trillion the year after that.

A few bank bankruptcies are manageable, but an interest rate shock to the massive derivatives market could take down the whole economy. As Michael Snyder wrote in a 2013 article titled A Chilling Warning About Interest Rate Derivatives:

“Will rapidly rising interest rates rip through the U.S. financial system like a giant lawnmower blade? Yes, the U.S. economy survived much higher interest rates in the past, but at that time there were not hundreds of trillions of dollars worth of interest rate derivatives hanging over our financial system like a Sword of Damocles. …

[R]ising interest rates could burst the derivatives bubble and cause “massive bankruptcies around the globe” [quoting Mexican billionaire Hugo Salinas Price]. Of course there are a whole lot of people out there that would be quite glad to see the “too big to fail” banks go bankrupt, but the truth is that if they go down, our entire economy will go down with them. … Our entire economic system is based on credit, and just like we saw in 2008, if the big banks start failing, credit freezes up and suddenly nobody can get any money for anything.

There are safer ways to design the banking system, but they are not likely to be in place before the quadrillion dollar derivatives bubble bursts.

Snyder was writing 10 years ago, and it hasn’t burst yet; but this was chiefly because the Fed came through with the “Fed Put” – the presumption that it would backstop “the market” in any sort of financial crisis. It has performed as expected until now, but the Fed Put has stripped it of its “independence” and its ability to perform its legislated duties. This is a complicated subject, but two good books on it are Nik Bhatia’s Layered Money (2021) and Lev Menand’s The Fed Unbound: Central Banking in a Time of Crisis (2022).

Today the Fed appears to be regaining its independence by intentionally killing the Fed Put, with its push to raise interest rates. It is still backstopping the offshore dollar market with “swap lines,” arrangements between central banks of two countries to keep currency available for member banks, but the latest swap line rate for the European Central Bank is a pricey 4.83%. No more “free lunch” for the banks.

The US Fed: “federal reserve building” by Rafael Saldana is licenced by CC BY 2.0

Alternative Solutions

Alternatives that have been proposed for unwinding the massive derivatives bubble include repealing the safe harbor amendment and imposing a financial transaction tax, typically a 0.1% tax on all financial trades. But those proposals have been around for years and Congress has not taken up the call. Rather than waiting for Congress to act, many commentators say we

need to form our own parallel alternative monetary systems.

Crypto proponents see promise in Bitcoin; but as Alastair MacLeod observes, Bitcoin’s price is too volatile for it to serve as a national or global reserve currency, and it does not have the status of enforceable legal tender. MacLeod’s preferred alternative is a gold-backed currency, not of the 19th century variety that led to bank runs

when the banks ran out of gold, but of the sort currently being proposed by Sergey Glazyev for the Eurasian Economic Union. The price of gold would be a yardstick for valuing national currencies, and physical gold could then be used as a settlement medium to clear trade balances.

Lev Menand, the author of The Fed Unbound, is an Associate Professor at Columbia Law School who has worked at the New York Federal Reserve and the US Treasury. Addressing the problem of the out-of-control unregulated shadow banking system, he stated in a July 2022 interview with The Hill, “I think that one of the great possible reforms is the public banking movement and the replication of successful public bank enterprises that we have now in some places, or that we’ve had in the past.”

Certainly, for our local government deposits, public banks are an important solution. State and local governments typically have far more than $250,000 deposited in SIFI banks, but local legislators consider them protected because they are “collateralized.”

In California, for example, banks taking state deposits must back them with collateral equal to 110% of the deposits themselves. The problem is that derivative and repo claimants with “supra-priority” can wipe out the entirety of a bankrupt bank’s collateral before other “secured” depositors have access to it.

Our tax dollars should be working for us in our own communities, not capitalizing failing SIFIs on Wall Street. Our stellar (and only) state-owned model is the Bank of North Dakota, which carried North Dakota through the 2008-9 financial crisis with flying colors.

Post-GFC (the Global Financial Crisis of 2007-9), it earned record profits by reinvesting the state’s revenues in the state, while big commercial banks lost billions in the speculative markets. A number of state legislatures currently have bills on their books following the North Dakota precedent.

For a federal workaround, we could follow the lead of Jesse Jones’ Reconstruction Finance Corporation, which funded the New Deal that pulled the country out of the Great Depression. A bill for a national investment bank currently in Congress that has widespread support is based on that very effective model, avoiding the need to increase taxes or the federal debt.

All those alternatives, however, depend on legislation, which may be too late. Meanwhile, self-sufficient “intentional” communities are growing in popularity, if that option is available to you. Community currencies, including digital currencies, can be used for trade.

They can be “Labour Dollars” or “Food Dollars” backed by the goods and services for which the community has agreed to accept them. The technology now exists to form a network of community cryptocurrencies that are asset-backed and privacy-protected, but that is a subject for another column.

The current financial system is fragile, volatile and vulnerable to systemic shocks. It is due for a reset, but we need to ensure that the system is changed in a way that works for the people whose labour and credit support it. Our hard-earned deposits are now the banks’ only source of cheap liquidity. We can leverage that power by collaborating in a way that serves the public interest.

This article, posted in the Web of Debt blog site, first appeared on ScheerPost. Ellen Brown is an attorney, chair of the Public Banking Institute, and author of thirteen books including Web of Debt, The Public Bank Solution, and Banking on the People: Democratizing Money in the Digital Age.

She also co-hosts a radio program on PRN.FM called “It’s Our Money.” Her 400+ blog articles appear at

Source: Web of Debt blog, 13 March 2023

Know someone interested? Please share

Leave a Reply