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MONETARY POLICIES

Brexit and the Derivatives Meltdown

Brexit, Derivatives, Meltdown, Monetary policy, fx trader, forex

Brexit could trigger a $500 trillion derivatives meltdown, by forcing the EU to allow insolvent member governments and banks to write down debt. Italy is in financial crisis and is already petitioning for that concession. How to avoid collapse of the massive derivatives house of cards? Alternatives are considered.

Sovereign debt – the debt of national governments – has ballooned from $80 trillion to $100 trillion just since 2008. Squeezed governments have been driven to radical austerity measures, privatizing public assets, slashing public services, and downsizing work forces in a futile attempt to balance national budgets. But the debt overhang just continues to grow.

Austerity has been pushed to the limit and hasn’t worked. But default or renegotiating the debt seems to be off the table. Why? According to a June 25th article by Graham Summers on ZeroHedge:

. . . EVERY move the Central Banks have made post-2009 has been aimed at avoiding debt restructuring or defaults in the bond markets. Why does Greece, a country that represents less than 2% of EU GDP, continue to receive bailouts instead of just defaulting?

Summers’ answer – derivatives:

[G]lobal leverage has exploded to record highs, with the sovereign bond bubble now a staggering $100 trillion in size. To top it off, over $10 trillion of this is sporting negative yields in nominal terms. . . .

Globally, over $500 trillion in derivatives trade [is] based on bond yields.

But Brexit changes everything, says Summers. Until now, the EU has been able to reject debt forgiveness as an alternative, using the threat of financial Armageddon if the debtor country left the EU. But Britain has left, and Armageddon hasn’t hit. Other Eurozone nations can now threaten to do the same if they don’t get debt forgiveness or a restructuring.

The First Domino – Italy

That has evidently started happening, with Italy as the first challenger of EU rules. On June 27th, Ambrose Evans-Pritchard reported in the UK Telegraph that the first serious casualty of the Brexit contagion had struck. The Italian government is preparing a €40 billion rescue of its financial system, as Italian bank shares collapse. The government is now studying a direct state recapitalization of Italian banks, to be funded by a special bond issue. They also want a moratorium of the bail-in rules and bondholder write-downs, although those steps are prohibited under EU laws.

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