Derivatives, Dark Liquidity, And Increasing Systematic Risk -

Derivatives, Dark Liquidity, And Increasing Systematic Risk - - Protection & Profit Potential

“Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: we view them as time bombs, both for the parties that deal in them and the economic system.”

“…The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear…”

“…In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” (emphasis added)

We consider how the exponentially increasing proliferation of OTC (over-the-counter) derivatives is dramatically increasing Systemic Risk and what steps can be taken to protect and potentially profit from this proliferation.

Generically speaking, a “derivative” is an entity whose value is derived from the value of some other entity. Hence the term “derivative.”

In the context of the financial markets, derivatives are Special Performance Contracts between two parties often called ‘party’ and ‘counterparty.’

Though there are many kinds of derivatives, three of the most common are stock options and commodities and financial futures options. A futures contract itself is a derivative – some refer to this as a first order derivative. An option for a futures contract is a second order derivative. In other words, its value is derived from a first order derivative (the underlying futures contract) which has its value derived from the underlying commodity involved be that corn, wheat, cocoa, etc. Similarly, financial futures contracts on currencies, Treasury Securities (T-Bonds, Notes, etc.), and Equities Indices are derivatives also.

One of several primary reasons that financial institutions and others engage in derivatives transactions is because of “leverage.” Leverage simply gives the holder of a derivatives contract an opportunity to make profit in the order of magnitude of many hundreds of percent more than the amount capital he put at risk. On the other hand, derivatives contracts often give one party to the derivatives contract risk of similarly high multiples of liability which, at times, can approach becoming unlimited liability.

The foregoing suggests one major incentive for derivatives creation: profit. (And there are other incentives, e.g. ostensible hedging against losses.)

But suppose a counterparty (on the losing side of a derivatives contract) cannot pay?

The foregoing question highlights a crucial distinction between Exchange-Traded Derivatives Contracts whose performance is guaranteed by a Clearinghouse and Over-The-Counter derivatives contracts (OTC) whose performance is typically NOT guaranteed by an entity other than the contracting party and counterparty.

That difference is a huge difference for several reasons. For example, note that Exchange-Traded Contracts (such as typical futures contracts for corn, wheat, crude oil, gold, Treasury Bonds or the U.S. Dollar via the USDX) are visible and somewhat public (being traded in a public market), and, typically, clearinghouse guaranteed. That is, if one party to an Exchange Traded Contract defaults, the clearinghouse in on the hook to make good on that contract if the counterparty fails to make good on it. This provides extra layer of security both for the parties to the contract and, importantly, also functions as security for the entire market in Exchange-Traded Derivatives Instruments.

On the other hand, OTC derivatives are far more risky and far less transparently visible (if visible at all!) to the public than are Exchange-Traded Contracts. OTC derivatives are a form of “dark liquidity” since their existence and terms are often known only to the party and counterparty (see Deepcaster’s Alert of 4/18/07 “Profiting from ‘Dark Liquidity’ and Other Systemic Risks” at www.deepcaster.com.)

Consider the characteristics and risks of “darkly liquid” OTC derivatives transactions often conducted by large institutions in “dark pools” (i.e. not in a public market):

The significance of “dark pool” transactions cannot be underestimated - - a recent estimate is that 10% of all equity transactions occur in “dark pools,” and that this number is growing.

One may obtain information about such dark pools from finextra.com or financetech.com websites, for example. For those not inclined to visit these websites to read the very revealing articles, the following excerpts taken from those websites in April, 2007 and February, 2008 will provide a sampling of the import of ‘dark liquidity’:

‘Dark algorithms,’ et al… (JP Morgan’s) “Neovest has established connectivity to 15 ‘dark pools’ of liquidity - - trading networks that do not publish quotes in the open market…”

“Neovest currently provides access to over 100 broker destinations and a range of dark pool algorithms….”

Regarding Goldman Sachs new platform “…the new platform will provide customers with access to deals that are not offered publicly on any exchange…(to) provide clients with access to dark liquidity pools.”

Regarding the ITG ‘dark liquidity crossing platform,’ “the system’s total anonymity ensures that there is no leakage of information into the market and therefore price impact is minimized, says ITG.” (emphasis added)

Regarding dark liquidity pools run by ‘dark book’ algorithms: “Earlier this year electronic broker Instinet launched a ‘stealth liquidity aggregation algorithm’ called “Nighthawk” and “JP Morgan Chase has launched Aqua and Arid, two institutional trading algorithms that have been designed to stealthy trade stocks on dark books - - trading networks that do not publish quotes in the open market…”

Apparently, despite the increasing problems with “dark liquidity” derivatives, at least some of the major institutional players still (i.e. in February 2008) savor playing in this “dark” arena:

“Turquoise enters testing phase”…the turquoise exchange” will begin trading in 300 liquid stocks in September and gradually roll-out to encompass 1200 stocks in a “darker liquidity pool” (emphasis added) finextra.com, February 14, 2008

And, from an article of October 22, 2007 (well after the August, 2007 credit market freeze-up):

“Fidessa to provide access to Instinet Japan”…”…as a result of the agreement Fidessa users are now able to access Instinet Japan’s full suite of algorithms, global DMA platform…and to dark liquidity pool platforms…”

From financetech.com (on December 12, 2007), we learn that while many U.S.-based institutions are not acknowledging the lethal risks inherent in dark liquidity pools, it appears that some of Europeans are acknowledging the toxicity:

“Dark pools have been a hot topic lately in domestic equities markets as institutional investors turn to the alternative sources of liquidity for high levels of automation, anonymity and block-crossing opportunities. Despite their increasing popularity in U.S. markets, however, dark pools are finding few takers in foreign markets, according to a new market study from Celent.

Dark liquidity pools sponsored by brokers and exchanges currently make up 7 percent to 10 percent of equities share volume in the U.S., a number which is steadily increasing, according to the Boston-based research and consulting firm. By contrast, Celent reports, in the European equities market, all types of alternative trading systems (including dark pools) account for less than 1 percent of the market.”

Clearly, the “dark liquidity” market is still quite significantly alive, if not altogether well.

In considering ‘dark liquidity,’ ‘dark pools,’ ‘dark algorithms’ and such, Deepcaster’s initial reaction was “what about the ‘Theology’ of the free and open and fair marketplace with a level playing field” with which we are inculcated?” And “what about the risks?” Don’t all these ‘dark vehicles’ greatly increase the risks in the market?

And do they not also provide manifold opportunities for The Cartel* to implement Market Interventions without scrutiny? Consider:

1) It is pretty clear that the ‘dark pool algorithms’, which are at the heart of systems designed to trade large orders in liquid markets, enable automated trading operations otherwise known as “program trading.” But haven’t automated trading platforms played a big part in major company and market meltdowns?

2) Isn’t an essential part of any investors’ sensible risk evaluation a function of evaluating counterparty risk? That is, a counterparty is the party who takes the other side of any particular investment transaction in which any of us is involved? But the capacity to make good on any such transaction is typically solely a function of counterparty strength or weakness. In OTC dark liquidity transactions there is typically no clearinghouse guarantee. Suppose the counterparty fails? And suppose the counterparty on any particular investor transaction is at great risk because of its ‘dark book’ transactions with other ‘dark’ parties. Who would know, and how could the risk be evaluated?

Indeed, we certainly have enough recent examples of Counterparty Failure to cause concern. Consider that the Amaranth Hedge Fund in recent months and Long-Term Capital Management in recent years are only two examples of this.

3) Moreover, consider the foregoing in conjunction with other relevant observations by noted financial observers:

“The inflationary recession continues to deepen with economic reporting generally surprising markets on the downside of expectations and inflation surprising markets on the upside.” April 3, 2007 Flash Alert, John Williams, Shadow Government Statistics. That is, Williams’ is describing our current state of stagflation, nearly one year ago.

Couple this observation with one attributed to Mark Precter (the Elliott Wave theorist) which we paraphrase as follows: “Currency inflations can go on forever, but credit inflations have a finite end point.” Indeed are we not seeing the beginning of the end of the massive (Fed Caused) Housing and Credit Market inflation that we have seen in recent years manifested, for example, in the New Century Financial bankruptcy at the beginning of April, 2007?

4) And what about “Fundamental Fairness” and “Level Playing Fields” in The Markets? Equal timely access to price information is essential to fairness to the investing public but “dark pools” and “dark transactions” in principle limit such information to the privileged few!

5) And what about “conflicts of interest?” One blogger wrote: But if a bank sets up an (dark pool) exchange, some of the biggest traders on the exchange will also be the bank’s biggest customers in other areas. This is a massive conflict of interest situation. Remember what happened in the 1990s when investment banks noticed that their equity research divisions could be used as a marketing tool? Imagine using execution speeds and pricing for the same purpose.

6) And what about lack of oversight? Who is watching the watchers, if indeed there are any watchers?

*We encourage those who doubt the scope and power of Intervention by a Fed-led Cartel of Central Bankers to read Deepcaster’s January, 2008 Letter containing a summary overview of Intervention entitled “Market Intervention, Data Manipulation - - Increasing Risks, The Cartel End Game, and Latest Forecast” at www.deepcaster.com> at Latest Letter. Also consider the substantial evidence collected by the Gold AntiTrust Action Committee at www.gata.org for information on precious metals price manipulation. Virtually all of the evidence for Intervention has been gleaned from publicly available records. Deepcaster’s profitable recommendations displayed at www.deepcaster.com have been facilitated by attention to these “Interventionals.”

The lack of transparency, in dark liquidity pools and dark books, lack of the ability to evaluate counterparty strength, conflicts of interest, and the ongoing credit bubble and housing bubble bursting certainly do not bode well for the financial system or for portfolios.

Counterparty failure is not the only cause of OTC derivatives failure in the dark transactions universe.

Real world (as opposed to the darkly liquid “paper world”) economic surprises can indeed be the cause of Dark Derivatives Systemic Failure. That is, automated (or other) trading programs based on “dark algorithms” and trading “dark liquidity” will fail because of the flaws in their design. In other words, economic circumstances change and these changes unexpected or unanticipated by the dark trading Model Makers can result in serious losses among one group of counterparties that render the entire daisy chain susceptible to failure.

The LTCM debacle is a classic example of this. The Model Makers failed to anticipate a major financial market development - - Russia’s default on bonds and devaluation of the Ruble. The resulting Daisy Chain of losses nearly brought down the whole financial system.

Since OTC derivatives are typically made between two institutional counterparties, and since they often employ leverage, the default of one institutional party can create an extraordinary loss/es for its counterparty (and consequences for the entire financial system) far in excess of the probable risk which was contemplated when the transaction was entered into.

And there is the rub. The failure of one firm has a cascading effect on countless others because of the way the risks are offset to numerous other counterparties. Think Enron.

Indeed, the entire financial structure is only as solid as the balance sheet of the weakest link in the Dark Derivatives parties and counterparties Daisy Chain.

According to the Bank for International Settlements (BIS – the Central Bankers Bank) the notional amount of derivatives outstanding was about $516 trillion in June, 2007. The term “notional value” is a slippery one but effectively means the potential maximum value of the contract. Strictly speaking, “notional value” is the total value of a leveraged position’s underlying assets.

On the other hand, the market value is often much less because the full potential (notional) value is thought to be improbable of being reached. Indeed, the BIS reports that some $516 trillion notional value OTC derivatives had a market value of “only “ something in excess of $11 trillion.” Nonetheless, significant numbers of defaults of parties to the $11 trillion ostensible market value in OTC derivatives could wreak havoc on the entire financial system.

Much more important from a systemic perspective is that if one party to a derivatives contract defaults, the magnitude of that default is typically the full notional value, not “merely” the market value. And defaults of some parties to OTC derivatives contracts are inevitable.

The Amaranth Hedge Fund’s collapse of a few months ago and the LTCM collapse of a few years ago provide a graphic demonstration of the lethality of OTC derivatives.

As we are learning, the massive risks associated with OTC derivatives are laced throughout the financial system. Just a few weeks ago, who would have thought that a Big Pharma company Bristol Myers Squib would have to take a quarter of a billion dollar write down as a result of its derivatives transactions. And who would have thought they would have to give “guidance” that more write-downs might have to be made? Thus, it is not surprising that Warren Buffett called derivatives “toxicity…financial weapons of mass destruction.”

Indeed, consider the following data on OTC derivatives creation and the troubling acceleration of their creation.

Consider the import of the data from the BIS' own website - - Review Table 19 at www.bis.org. Follow the path: Statistics>Derivatives>Table19. Note that as of December, 2006 there were:

$6.475 trillion commodities contracts (excluding gold) outstanding $40.239 trillion foreign exchange contracts outstanding $291.115 trillion interest rate market contracts outstanding

But consider the stunning increases in OTC Derivatives in just the six months between December, 2006 and June, 2007. As of June, 2007 there were outstanding:

$7.141 trillion in commodities (excluding gold) contracts, an approx. $666 billion (approx. 10%) increase in only six months $48.620 trillion in foreign exchange contracts, an $8.381 trillion (approx. 20%) increase in only 6 months. $346.937 trillion in interest rate market contracts, a $55.822 trillion (approx. 19%) increase in only 6 months

What is also obvious from a comparison invited by Table 19 - - comparing June, 2005 figures with June, 2007 figures - - is the increasing Systemic Threat The Cartel’s* Interventional Regime imposes (see Deepcaster’s January, 2008 Letter “Market Intervention, Data Manipulation, Increasing Risks, The Cartel End Game and Latest Forecast”). Note also on Table 19 the dramatic jump in most categories of derivatives from June, 2005 to June, 2007.

Increases in the amounts of OTC derivatives outstanding for the Gold Market are perhaps the most stunning:

From the $359 billion outstanding at end-June 2004 they nearly tripled to $1,051 trillion at end-June 2007, an increase of approx. 290% (source: BIS “Table A, OTC derivatives market, Triennial Central Bank Survey of Foreign Exchange and Derivatives market Activity”).

Note: While BIS Table 19 shows a drop in OTC derivatives contracts for gold in the 6 months from the end-December 2006 figure of $640 billion to the end-June 2007 figure of $426 billion, it should be noted that the end-June 2007 number ($1.051 trillion) from the BIS Triennial Survey is a more comprehensive number, generically akin to the “upward revisions” which the U.S. BLS regularly makes. Doubtless some substantial portion of the foregoing OTC derivatives contracts are for entirely commercial purposes, but with publicly visible Exchange-Traded derivatives also available for commercial purposes (and considering publicly traded companies take incur considerable risk by engaging in “dark liquidity” OTC transactions) it strains credulity to claim that most or all OTC contracts are for purely commercial, i.e. non-interventional, purposes. It is clear to us that the near tripling of the derivatives contracts devoted to Gold, to over a trillion dollars in three years could have no other cause than the Fed-led Cartel* of Central Bankers need for them to suppress the Gold price. Indeed, given the relatively small capitalization character of the Gold Market, what other cause could there be?

We have already seen two negative consequences of the proliferation of OTC derivatives (Dark Liquidity) throughout the financial system. One is the ongoing subprime default debacle and the other related one is the credit market freeze-up, which first became apparent in August, 2007.

It is not surprising that the proliferation of darkly liquid OTC derivatives should result in a credit market freeze-up. After all, who knows, for example, whether a “package” of Collateralized Debt Obligations that a financial institution is considering buying contains some securities on which the counterparty/ies is/are about to default?

No to oversimplify too much, it is this characteristic of “darkness” that caused the credit market freeze-up of August, 2007. No one wants to lend because they do not trust each other’s books or what is even worse, they do not understand what is on the books! Very few understand these things since they are all based on computer models, dark algorithms and assumptions, but that is the very thing that works to kill confidence when no one can understand who has what. The consequence: lending institutions do not want to lend because they cannot get a clear handle on the strength of the balance sheet of the firm they might be lending to.

The response of the U.S. Federal Reserve (a privately owned for-profit entity) has been to increasingly liquefy the banking system by providing even more (borrowed) liquidity via a discount window and reducing rates.

But there are great systemic perils which arise from creating “borrowed liquidity” (the approach preferred by The Fed) versus the healthier “earned liquidity” (e.g. savings) on which Deepcaster has commented in his January, 2008 Letter “Market Intervention, Data Manipulation, Increasing Risks, The Cartel End Game, and Latest Forecast” and in “Profiting From Dark Liquidity and Other Systemic Risks (4/8/07 Alert at www.deepcaster.com).

The core of the systemic problem and increasing risk is that beginning after the Tech Wreck of 2000, the Fed-led Cartel* of Central Bankers created and allowed far too much borrowed liquidity (i.e. debt) to be created, creating the credit bubble and the mortgage bubble. And this excess liquidity creation continues to this day - - M3 is increasing at more than 15% per year, about a 5 year doubling time, according to shadowstats.com!

The realities of the marketplace are causing these bubbles now to be in the process of being punctured, resulting in increasingly negative consequences and increasing systemic risk for the financial markets and the broader economy, as well.

“But for systemic intervention and manipulation by the Federal Reserve, it appears we might be contemplating a collapsed U.S. banking system and a looming deflationary great depression that could have dwarfed the bad times of the 1930s. Such is the good news. The bad news is that with those same systemic interventions, the Fed is locking in a hyperinflationary great depression in the decade ahead, with the turmoil possibly breaking by 2010 or earlier.” (emphasis added)

“The mounting evidence is that the Fed-led Cartel is knowingly creating conditions designed to force the U.S. to eventually have to choose between a hyperinflationary great depression and The Cartel’s ominous “End Game” which Deepcaster has described in its January, 2008 Letter.

Let us conclude by examining some examples which threaten the financial system as a whole.

Consider one Sector - - The Bond Sector. This Sector reveals that the damage to institutions built on “collapsing paper” has only just begun. If not contained, this damage could spread throughout the entire Financial System.

There are about $10.4 trillion of dollar-denominated bonds of which $7 trillion are prime AAA and $1.4 trillion are subprime BBB. Of these, the prime bonds are projected to lose 30% of their market value or about $2.1 trillion, the subprime to lose 80% of their value or about $1.1 trillion and the ALT-As to lose another $1 trillion, according to Jim Willie. From the beginning of the subprime crisis, the total value of bond losses is expected to be about $4.2 trillion!

The Mortgage Bond Market write-downs have only just begun as Deepcaster extensively detailed in an article on “Collapsing Paper” in early February, 2008. [Note: Erratum, but likely in time only: In Deepcaster’s recent piece on mortgage bond losses, we relied on PhD. statistician Jim Willie’s calculations that the Prime AAA Bonds Index on credit default swaps for mortgage bonds had lost about 30%. Willie has now amended his position to contend that there will “in time be 30% losses on prime mortgages.” Deepcaster agrees, the basic point about massive losses in the Mortgage Bond Market is still a sound one, nitpickers notwithstanding.]

One of the many negative consequences of these losses is that financial institutions (holding these bonds in their portfolios) are forced to make asset write-downs, which reduce reserves. In addition, when reserves are already being destroyed by loan defaults, and when the reserve defaults are magnified by the fractional reserve system, the problems are compounded.

Two methods for maintaining reserves are going to the Fed’s discount window and/or calling in loans. But employing these methods creates some negative consequences for consumers and for the entire financial system. Depleted reserves are one reason we already hear that some bankers intend not to allow additional draws from Home Equity Lines of Credit, and why some credit card companies are talking about increasing rates or calling in their loans. And further bank borrowing exacerbates the “borrowed liquidity” problem which Deepcaster has demonstrated is “A Cure Worse Than the Disease” (see Deepcaster’s January 2008 Letter at www.deepcaster.com).

Thus, for financial institutions holding large chunks of what is now considered “junk paper” institutional failure is a real possibility. And many of these institutions can forget about a Warren Buffett riding to the rescue. (Buffet’s offer to provide reinsurance to certain monoline bond insurers, thereby guaranteeing the ratings of some of their insureds, extended only to their municipal bond portfolios, not to corporate bonds.)

Worse yet, the list of municipal bond auction failures is growing. Increasing numbers of municipalities cannot get funding for schools, hospitals, and roads, etc. The Fed’s favored Primary Dealers claim they cannot lend any more due to heightened risks which were generated by, and reflected in, the famous August, 2007 credit freeze-up. But these are the same Dealers who have gotten rich gouging the municipalities in better days. Clearly, it is likely there will be more problems coming in this financial sector.

Following the aforementioned causal thread reveals only one road to a seriously impaired market sector. Unfortunately, there are several others.

Now in light of the above consider overall health of the financial system. Recent Bank for International Settlements (BIS - the Central Bankers Bank) data releases reveal some $516 trillion (notional value - - see above) in OTC (Over-the-Counter) Derivatives outstanding as of June, 2007. Consider also that OTC Derivatives constitute highly risky “Dark Liquidity” for the several reasons set out in Deepcaster’s April 8, 2007 Alert entitled “Profiting From Dark Liquidity and Other Systemic Risks.” Exchange-Traded Derivatives by contrast are relatively transparent and are typically less risky because a clearinghouse often guarantees their performance. Not so with OTC derivatives.

Deepcaster has laid out the evidence, on several occasions, that a substantial chunk of the multi-trillion in OTC derivatives outstanding are available for, and used for, market manipulation by The Fed-led Cartel* in various multi-trillion-dollar tranches.

But it is important to reiterate that there are at least three major problems flowing from this mountain of toxic OTC derivatives weapons of financial mass destruction.

First, as indicated above, they constitute “Dark Liquidity” transactions in which the “outside world” (and indeed, sometimes one party to the derivatives contract) may not fully know the strength or weakness of their counterparty/ies. And, typically, entities other than the parties and counterparties know little or nothing of those derivatives and their risks, other than, perhaps, that they exist.

The key implication is that these derivatives’ darkly liquid character often makes attributing a “market value” to them an exercise in mythmaking.

It also makes putatively “safe” investments in “Safe Haven” sectors, for example, in a “Big Pharma” company, not so safe after all. Who could have known that Bristol Myers Squibb had derivatives losses until they announced a quarter billion dollar write down recently? And Bristol indicated there might be more such losses to come. So much for Big Pharma as a “safe haven.” Indeed, so much for other traditional “safe havens” which the OTC derivatives disease has infected.

Second, OTC Derivatives creation has been accelerating at an increasing rate. To accommodate increasing financial sector imbalances (created largely by their own flawed policies) The Fed-led Cartel* has had to accelerate derivatives creation at increasing rates (see Deepcaster’s January, 2008 Letter “Market Intervention, Data Manipulation, Increasing Risks, The Cartel End Game, and Latest Forecast” at www.deepcaster.com). This manifests an increasing reliance on (and thus increasing risk from) OTC derivatives as a means of market stabilization, as well as Intervention.

The third problem has to do with the slippery term “Notional Value” discussed above. The apologists as it were, for massive derivatives creation (i.e. typically, those who understate the risks) claim that Notional Value is not Market Value. And since market values are so much less than notional values, they claim the overall risk is correspondingly less. That is true to a point.

But the “market value” of the $346 trillion plus in Notional Value Interest Rate Contracts reported by the BIS (06/07), for example, is nonetheless some $6 trillion. A pretty hefty “real” market value, with potentially great impact if a significant portion default.

But there is an even more significant consideration we reiterate for emphasis; typically, upon default of one counterparty to an OTC derivative contract the notional value becomes the full value of the loss!

And when that Notional Value becomes full value due to one counterparty default (and of course we are seeing an increasing number of counterparty defaults - - even the Big Media occasionally covers them) the negative “ripple effect” on the primary party and his other counterparties, increases the likelihood of massive losses and dislocations system wide. And the first recent realization of that phenomenon was in the subprime default-generated-credit-market-freeze-up of August, 2007.

The practical consequence of the foregoing is that The Systemic Meltdown Threat becomes ever greater, as OTC Derivatives Creation accelerates.

One important consideration: if the Threat were “only” one of such companies (whose businesses are built on, or involve, derivatives - paper) collapsing, perhaps the strength of the underlying “Tangible Sectors” (i.e. manufacturing, agricultural and related) of the U.S. economy could serve as a buttress against broad-based damage suffered as a result of “paper” based companies collapsing.

However, the U.S. economy has been dramatically weakened in recent years by outsourcing, globalization, gutting of the manufacturing base and particularly by The Fed’s profligate increases in money supply and credit availability beginning in 2001. Thus, as a consequence, the role of the U.S. as the driver of the World Economy and the U.S. Dollar as the World’s Reserve Currency is likely coming to an end as is the prosperity and, indeed, the very existence of the U.S. middle class.

Consider Paul Craig Roberts’ (former Under Secretary of the Treasury under President Reagan) view of the health of the U.S. Economy:

“It is difficult to know where Bush has accomplished the most destruction, the Iraqi economy or the U.S. economy.

In the current issue of Manufacturing & Technology News, Washington economist Charles McMillion observes that seven years of Bush has seen the federal debt increase by two-thirds while U.S. household debt doubled.

This massive Keynesian stimulus produced pitiful economic results. Median real income has declined. The labor force participation rate has declined. Job growth has been pathetic, with 28% of the new jobs being in the government sector. All the new private sector jobs are accounted for by private education and health care bureaucracies, bars and restaurants. Three and a quarter million manufacturing jobs and half a million supervisory jobs were lost. The number of manufacturing jobs has fallen to the level of 65 years ago.

“The Dollar’s Reserve Currency Role is Drawing to an End,” vdare.com, January 25, 2008

Of course, the United States has been brought to this sad pass primarily by the policies of The Federal Reserve coupled with globalists who have pushed the United States into NAFTA, CAFTA, and other U.S.-economy-destroying and middle-class-destroying agreements.

Deepcaster asks: how can so-called “free” trade agreements be fair to the American workers (or to U.S domestic businesses) if it means they have to compete with the wages (and production costs) of workers (and businesses) in countries in which wage rates (and production costs) are a tenth or less than those in the United States? In sum, our view is that “fair trade” is more conducive to economic health than ostensibly “free” trade.

A far healthier U.S. economy existed in the 1950s when the United States was more self-reliant, less globally entangled, much less indebted, and had its own domestic market as its largest market, by far.

“Economists have romanticized globalism, taking delight in the myriad of foreign components in U.S. brand name products. This is fine for a country whose trade is in balance or whose currency has the reserve currency role. It is a terrible dependency for a country such as the U.S. that has been busy at work off shoring its economy while destroying the exchange value of its currency.”

Indeed, the Markets have already begun to experience, and will continue to experience, what Deepcaster calls The ‘Darkly Liquid (i.e. OTC) Derivatives Destructive Ripple Effect.’

To oversimplify only a bit: In the Summer 2007 upward interest rate resets of not just subprime mortgages, but also other home mortgage categories such as Prime (AAA), and Alt.-A began to cause an increase in the mortgage default rate.

But the problem then was (and still is) that many of those loans had been bundled together in ‘packages’ to institutional investors. In turn, these packages may or may not have been resold to other investors, in what becomes a ‘Daisy Chain.’

Many of these packages were ‘constructed’ in the legal form of derivatives known as Mortgage Bonds.

But the key point is that most of these packages had, and still have, ‘darkly liquid’ characteristics (see above). These characteristics raise perfectly legitimate questions such as: who knows what is in the packages? Who knows how many more defaults are ABOUT to occur in these packages, but have not yet?

Thus, the credit markets experienced their August, 2007 freeze-up, predictably. Who wants to buy or sell these darkly liquid instruments when no one knows what is in them? And since in principle there is no public market for such dark liquidity instruments, the “market value” fell to, well, zero, in many cases. And, in fact, many of those instruments which can not be marketed today have, de facto, zero market value. Deepcaster names those “ZMV” derivatives.

Result: Prime, Alt-A, and Subprime Mortgage Bonds are looking at multi-trillion dollar losses. Worse, the industry does not acknowledge the magnitude of these losses, nor does the complicit Big Media report them.

Banks and other institutions holding these bonds have had to, and will continue to have to, write down the value of their portfolios which, in the Banks’ for example has, and will continue to, cause them to have difficulty (if not the impossibility) in meeting their reserve requirements.

[The Fed acted to temporarily ease this problem by opening the Discount Window via a Term Auction Facility (TAF) whereby Banks can borrow reserves, as it were. But this creates even more borrowed liquidity (as opposed to earned liquidity) which Deepcaster has characterized as ‘The Cure Worse Than the Disease’ - - a phenomenon fully explained in Deepcaster’s January 2008 Letter.]

Many of these Bonds had their AAA ratings insured (guaranteed) by the so-called Monoline Insurers. But now these Bond Insurers are facing liabilities of billions, and possible bankruptcy resulting from the losses in ‘market value’ of the Bonds.

And of the consequent several bad results is that with the aforementioned ratings, and thus ratings insurers, failures, the Municipal Bond Market (and other Bond Market Sectors) are becoming increasingly frozen.

The New York Port Authority, for example, could not get sufficient purchasers of their Bond Offering recently, and thus the Offering failed!

Indeed, the number of failed Municipal Bond Auctions has risen dramatically in recent weeks!

In sum, one brilliant commentator summarizes The (Private, For-Profit) Fed’s role at the center of this Derivatives Disaster:

“It seems as if, more and more, the banks are dumping those worthless CDO’s, SIV’s, and the rest of the alphabet soup trash they have right into the lap of the Fed which is in essence, monetizing them. It is beyond obscene what is taking place when we stop to consider what has happened. The greedy ******** that infest Wall Street have created mountains of this worthless junk which served to initially enrich themselves by inflating their profits on paper and allowing stock prices to rise along with fat-cat corporate bonuses and other perks. Then the bottom fell out and they had no one to sell them to so they turn around and get to dump this **** on the Fed which creates more money out of air to pay for them. What an amazing corrupt scam….”

Indeed, Exchange-Traded, Clearinghouse guaranteed, Publicly Marketed, Transparently Visible (as opposed to darkly liquid OTC) derivatives play a very valuable role in our financial and commodities markets!

But if the system is to be saved from collapse, the elimination of some kinds of OTC Derivatives, and the strict and publicly visible regulation of others, is essential.

Also essential to prevent eventual systemic collapse, whether through an eventual hyperinflationary depression, or otherwise, is the re-linking of fiat currencies to Gold and Silver, i.e. to Real Money, and not just to some other Fiat Paper.

Such re-linking could prevent the “Collapsing Paper Derivatives Problem,” which if allowed to continue could be both the catalyst and partial cause of a Climacteric Systemic Collapse.

It certainly seems that the lack of transparency in dark pools and dark books, lack of ability to evaluate counterparty strength, conflicts of interest, and the continuing stagflation and impending credit bubble bursts certainly do not bode well for the future or for portfolios, unless one implements an approach such as the following which addresses these issues.

So how does one protect from and profit in spite of these risks? This poses a considerable challenge. A significant focus of Deepcaster’s Letters and Alerts is aimed at answering these questions. But the following observations may provide some partial answers:

1) Keep a significant portion of your wealth in tangible assets including Precious Monetary Metals (in amounts subject to timing considerations) and Strategic (e.g. Crude Oil) and select agricultural commodities which the public needs and regularly uses. Deepcaster has identified certain of these assets and addresses the timing considerations in his recent Letters and Alerts.

Even though The Cartel may manipulate the prices of these tangible assets down from time to time, in the long run one will be rewarded for owning them, if they are in great demand and that demand is relatively inelastic.

2) Attempt to make, although it may be very difficult, an evaluation of counterparty strength. Regarding options, for example, are they clearinghouse guaranteed? And how strong is the clearinghouse?

3) “Go local” in banking, and commercial, and essential goods supply relationships. “Self reliance” and “local reliance” are key goals.

4) Develop an investing and trading regime for certain key tangible assets markets to minimize or avoid the impact of Cartel-initiated takedowns. In this connection, Deepcaster has developed an approach for investing and trading in the Precious Metals Markets described in its April, 2007 Letter at www.deepcaster.com.

5) Stay informed about the currently ongoing implementation of “The Cartel End Game” as described in Deepcaster’s August 11, 2006 Alert and June, 2007 Letter at www.deepcaster.com.

8) Stay informed. Given the rapidity, magnitude, and increasing significance of “dark liquidity” transactions, failure to stay informed can be lethal. But, since the transactions are “dark” staying informed is difficult, to say the least. And that is a primary challenge.

[“It seems as if, more and more, the banks are dumping those worthless CDO’s, SIV’s, and the rest of the alphabet soup trash they have right into the lap of the Fed which is in essence, monetizing them. It is beyond obscene what is taking place when we stop to consider what has happened. The greedy ******** that infest Wall Street have created mountains of this worthless junk which served to initially enrich themselves by inflating their profits on paper and allowing stock prices to rise along with fat-cat corporate bonuses and other perks. Then the bottom fell out and they had no one to sell them to so they turn around and get to dump this **** on the Fed which creates more money out of air to pay for them. What an amazing corrupt scam….”]

Fortunately, Congressman Ron Paul has introduced legislation to restore financial stability to America's economy by abolishing the Federal Reserve.

Click here to contact your congressional representative and ask him/her to co-sponsor H.R. 2755.

I have respect for you, TLR. However, I must ask: ''Why do you post such nonsense?''

Denonstration.

1) Derivatives are not and never have been ''Special Preference Contracts''. As regards commodity futures, options (which are derivatives) were, before 1934, called 'preferences', but the term your cited article uses is without referent in the financial world, afaik -- and I've traded derivatives very possibly longer than you've been alive. (Side thought: might be a term used by and among dingbat authors such as the author of this piece; most assuredly NOT a term in general currency.)

2) If you or anyone else is going to fulminate against something, ''Dark Risk'' or whatever, then please define your terms. The article did not. This is the typical lead tactic of the scaremonger, the drooling idiot, the Marxist, the anarchist, and the shjtbag. For further details on this point, consult either Hitlery or Osamabama.

3) Anyone who says that trading ANYTHING is a ''zero-sum game'' is so bloody stupid as to be laughable, and either never took or flatly failed his or her university courses in game theory. When one trades ANYTHING, a bit of capital is removed from the game via trading commissions and floor fees, which makes trading -- BY EFFING DEFINITION in game theory -- a negative-sum game, certainly not a zero-sum game.

There are at least 8 or 9 more objective disputations that can/could/should be made regarding that clown's silly article -- not philosophical disputations, but practical, real-world, trading objections. Just at the moment, I haven't the time.

However, if you want to push this sort of twaddle, m'friend, then I assure you that next time, I shall take the time to ram this economically illiterate scare-mongering right straight up your bum (or the author's, if you disavow your tolerance of his, her, or its advocacy).

My concern was that, since transaction in dark pool setting was not transparent to public, the public market does not accurately reflect the market dynamic. I was looking for an article which concretely illustrates how things can go wrong in such a situation.

There aren't many.

It is rather clear that the reason they use this mechanism is that they want to avoid the news of their transaction to get out in public, and affect the value of their stocks or other holdings. That is why they keep using the term "market impact," ergo no price change as the result of your transactions. Not directly anyway.

The purpose of dark liquidity pool is not so hard to understand. I don't know if similar practices have been around in the past on a small scale in an ad hoc manner. But it has become systematic mechanism recently, according to information I have been able to browse. It is rather disturbing that estimated 10% of U.S. market transactions are done completely off the public venue.

I am not in a position to pinpoint how the author of the above article messed up some detail on the interaction between derivatives and dark liquidity pool mechanism. Still, I believe that the very presence of the market creates the situation where shady transactions could go on among players in the know, at the expense of general investors who has no access to such a venue.

Good morning TLR, thanks for following up on these “dark liquidity pools”. I do an awful lot of trading in and out of the markets, not as much as a few years ago, but still fairly substantial. Up until about 2 years ago, when one would watch a Level II screen on a trading platform, Level II, being the order list of bids and asks on equities at differing price levels in real time.......well up until about two years ago, you would see the big investment bankers listed as buyers or sellers by their acronyms as market makers. GSCO for Goldman Sachs, LEHM for Lehman, MLCO for Merrill Lynch, SBSH for Citigroup, etc.

Anyway....one could determine, by watching, who was the prime mover of an equity on the buy or sell side for any given day. This particular market mover, say it was GSCO who was controlling the price was known as the “Axe”.

You would never take a trade against the “Axe”, but following along and taking their side of the trade could be quite profitable once you got a “feel” for who was the “Axe” for the day.

Well those days are gone, the big institutions are now moving their big blocks through these “dark liquidity pools” and transparent markets are becoming ever less and less so.

An article from 2006:

http://www.wallstreetandtech.com/opinions/larrytabb/showArticle.jhtml?articleID=191801383

Dark Is Hot. But Is It Good?

By Larry Tabb

Wall Street & Technology

8?07, 2006

Dark pools are all the rage. Those opaque matching venues where large blocks meet seem to be on everyone's hit parade. Whether it is Liquidnet’s valuation (which seems to have occurred eons ago), the preponderance of announced sell-side internal crossing engines, the development of dark algorithms, the buy side's desire to participate with hidden flow, or just the loss of NYSE market share causing firms to hunt more judiciously for an execution, dark is hot.
Dark pools range from completely opaque to semi-transparent, and their order flow can range from transient to stationary. Opaqueness impacts fairness, as the more-transparent the liquidity pool, the easier it is to be manipulated. More-transparent crossing networks, such as Liquidnet, solve this problem by not letting brokers or more-active traders onto the platform and by policing their community and evicting poachers. Other crossing engines with some transparency, such as Pipeline or Posit, give away such limited information that it is difficult to take advantage of.

The majority of dark pools, however, tend to be completely dark and either match order flow periodically (these are call markets such as Posit, Instinet or the Nasdaq Cross) or continuously as orders flow to traditional exchanges. ITG’s Posit Now, its continuous crossing network, and NYFIX Millennium leverage this transient matching model.

Brokers’ internal markets, however, tend to work a little differently. To develop active internal markets, brokers need significant amounts of two-sided order flow (buys and sells). Firms obtain this flow in three major ways: leveraging retail flow, hosting liquidity in the dark book and attracting order flow from third parities. All three of these models are now deployed.

UBS has made extensive use of its retail order flow in its internal dark market, PIN. Since retail flow tends to be a bit more two-sided, leveraging retail order flow is a significant advantage in increasing a firm's matching rate and attracting institutional and hedge fund liquidity. Goldman Sachs’ Sigma X platform extends its matching rates by attracting external liquidity providers. The majority of other bulge-bracket brokers are placing larger orders in the matching engine, so as their algorithmic, DMA or traditional flow moves through the crossing engine there are more opportunities to match.

But while dark is hot, is dark good? External crossing networks now execute approximately 5 percent to 8 percent of buy-side flow, while the largest sell-side firms cross approximately 6 percent to 10 percent of their institutional flow. Are we getting to a point where we should be concerned that the dark liquidity pools are beginning to impact the price discovery process of traditional markets?

Certainly the exchanges think so. At the SIA Market Structure Conference a few months ago, Catherine Kinney, president of the NYSE, had a few not-so-nice words to say about crossing - particularly broker internal crossing networks. She posited that dark books impair price discovery, and that every share that is crossed in the dark is a share that doesn't assist the market in determining an accurate price. Now, Ms. Kinney certainly has a vested interest in keeping flow on the exchange, but she isn't completely off base.

At what point should the market be concerned that limited amounts of retail order flow could adversely impact the price of very large blocks? Even if institutions are happy with their price discovery, are we as an industry comfortable with retail flow being matched against sophisticated flow and never making it to the market for all to see?

While all is fair in love and war, and what goes on in a dark room between consenting institutions and hedge funds is fine with me, when it comes to retail fiduciary responsibility, we should act as an industry before the regulators step in and mandate something that everyone will hate. So while dark pools are great for finding liquidity, let's be sure that these dark pools are honest fair, and provide best execution. While I am all for dark pools, it's black eyes I'm against.

Larry Tabb is founder and CEO of Westborough, Mass.-based TABB Group, a financial markets strategic advisory firm. ltabb@tabbgroup.com

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