The bank of international settlements just released a report revealing a derivatives time bomb that is set to explode in 2023.
There are secret derivatives that are off the balance sheet, hidden in the shadows.
How many secret derivatives are denominated in dollars?
Back in 2004, the BIS estimated it to be about $20 trillion. Today we are at $85 trillion.
The total amount of these types of derivatives are around $100 trillion.
These include foreign exchange swaps. Commonly called FX swaps.
FX Swaps
What is an FX swap?
An FX swap is a type of derivative instrument that involves the exchange of two different currencies on two different dates. It is usually used for hedging or speculation.
On the first date, one party will agree to buy a specified amount of currency at an agreed-upon rate from the second party. On the second date, the transaction is reversed.
The $15 trillion remaining ($100 trillion total – $85 trillion in dollar-denominated derivatives) are FX swaps that are denominated in currencies other than the dollar.
The dollar represents $85 trillion as we said before and 80% of this dollar-denominated debt is due within one year.
So what are these mysterious dollar liabilities, these derivatives, which Warren Buffett calls weapons of mass destruction and the mainstream media never talk about?
Not surprisingly, the mainstream media doesn't know they exist.
It starts with the next category in the BIS report, currency swaps.
Currency Swaps
Currency swaps are pretty much the same thing as FX swaps or very similar.
What I want all of you to remember is that all of these derivatives, all of this dollar-denominated debt, is off-balance sheet.
The marketplace doesn't even know this off-balance sheet debt exists.
To further dive into the details of this shocking report let's review some of the details I got from a report on the Bank of International Settlements website, bis.org.
This report is their quarterly review that just came out the other day. This is for December 2022 and I'll be discussing content on page 76 of 90.
“Dollar debt in FX swaps and forwards: huge, missing and growing”
Not exactly a title that inspires confidence in the global economy.
FX swaps, forwards, and currency swaps create forward dollar payment obligations
In other words, this is dollar-denominated debt that must be paid back in the future.
And these obligations do not appear on balance sheets and are missing in standard debt statistics. Non-banks outside of the United States owe as much as $25 trillion in such missing debt up from $17 trillion in 2016…
And keep in mind we're not talking about Credit Suisse and Deutsche Bank. We're talking about non-banks outside of the United States.
So actual real companies that produce stuff, among other things like pension funds and hedge funds Etc.
…Non-US Banks owe upwards of $35 trillion. Much of this debt is very short term and the resulting rollover needs to make for dollar funding squeezes…
In other words, the dollar doing exactly what GameStop did. Let's say a year ago when it went from $10 to whatever, $300 or $400, and then right back down.
…Policy responses to such squeezes include Central Bank swap lines. We talk about this all the time here, but these are set in a fog…
Their words, not mine.
…With little information about the geographic distribution of this missing debt…
This is all dollar-denominated debt that's off-balance sheet and is called derivatives.
Fed Policy tools cannot fix off-balance sheet problems like this
What the BIS is saying is yes the FED might have policy tools to combat a ticking time bomb like this but those policy tools can only be directed at specific countries.
In other words, the FED tools only work when they know exactly where the problem is and what country is being affected. Setting up a swap line with the Swiss Central Bank when it is in trouble makes sense.
However, how does the Fed know where all of these companies with financial WMDs strapped to their chests are hiding?
This scenario has huge Black Swan types of risk that we could see coming to the surface over the next 12 months.
Off-Balance Sheet Debt Coming Due (Soon), And It's A Huge Problem
I know many of you are scratching your head and saying WTF George, what on Earth is going on?
Now, I want to demystify these derivatives we've been talking about.
They're actually not that complex. Then you'll be able to understand why this $85 trillion in debt, that's completely off-balance sheet and is coming due within the next year, is such a big problem.
FX Swaps In More Detail
Now, this is one category of derivatives that are discussed in the aforementioned BIS report and once you understand this, it's very easy to understand the others.
So let's start by going over the swap Bank. They're right in the middle of a transaction, as you would expect.
They're taking their fees and facilitating transactions.
Let's suppose for a moment that we have two Firms in need of funding. On one side, we've got Firm A. Let's say they're in the United States.
On the other side, we've got Firm B and they are in Europe.
Both firms have a funding problem.
You see, they both have operations in the United States and Europe and they both need funding to expand.
Let's say they each need $10 million to buy some machinery to build their own respective factory's in the country where they are NOT domiciled.
Again the European company needs dollars to build in America, and the American company needs euros to build in Europe.
Since they're not domiciled in the area where they need local currency, they would be forced into the open FX market. This means extremely high-interest rates to borrow what they need.
A swap bank solves this problem.
What Is A Swap Bank?
A Swap Bank is a financial intermediary that facilitates the exchange of one currency for another, typically in order to facilitate cross-border transactions.
They are often used by companies that need to borrow in a foreign currency in order to pay for equipment or other investments.
Swap banks act as the middleman between the two parties involved in a currency exchange transaction.
They facilitate the conversion of currencies between buyers and sellers, allowing them to conduct business across borders without having to incur expensive foreign exchange fees.
When one party wants to buy or sell a currency for another, they can go through a swap bank.
At the end of the day what this simply boils down to is two entities coming to an agreement where they say hey if you borrow for me I'll borrow for you and we'll both come out ahead.
Why Do They Keep These Swaps Off-Balance Sheet
Real money that becomes an off-balance sheet item like this makes no sense whatsoever.
They're taking trillions, tens of trillions of dollars, and are just sweeping it under the rug and pretending that this massive amount of risk doesn't exist at all.
For answers, let's go right back to the BIS's website.
The debt remains obscured from view. Accounting conventions leave it mostly off-balance sheet, as a derivative, even though it is in effect a secured loan with principal to be repaid in full at maturity only footnotes to the accounts reported.
It's crazy to think that this is their best answer.
Let's dive into how this house of cards may come crashing down over the next year.
The End Game Is Actually Pretty Straightforward
The end game to this whole derivatives debacle will look a lot like the Great Financial Crisis x 1000.
The global economy has a $100 trillion dollar adjustable rate mortgage and payment is coming due within the next 12 months.
When these entities go to roll over their off-balance sheet debt they'll have to pay a much higher interest rate just like homeowners did during the GFC which caused them to default.
These higher interest rates will lead to a global recession.
We talk about the inversion of the yield curve predicting a recession in 2023 all the time. So if we go into a global recession then cash flow will decrease for these participating entities.
Also, the velocity of money circulating throughout the global economy will drop, creating an even bigger burden for the existing debt for these entities involved.
What happens if we get a global recession?
Cash flows decrease, we'll have a lower velocity of dollars, and the dollar likely appreciates in value relative to other fiat currencies.
If Firm A (an American company) needs euros to set up a plant in Europe and they cash flow in Euros and they swapped with Firm B (a European company) who also cash flows in Euros but their debt is in dollars, then this triggers a doom loop when the dollar goes up against the Euro.
At this point, servicing their debt because impossible.
This is the derivatives time bomb that the BIS outlined in its most recent report that is set to explode in 2023.