A-TRIZZLE

#JustDarioDaily 🚨DERIVATIVES ARE FINANCIAL WEAPONS OF MASS DESTRUCTION 🚨 Derivatives were invented as an instrument to transfer risk between two counterparts. In theory, when someone gains on a derivative trade, someone else loses. Nowadays, the volume of derivatives outstanding far exceeds the underlying assets they are supposed to be priced upon. This means that derivatives are no longer an instrument to transfer risk in the market used for pure hedging, but they became an instrument to bet on an outcome. However, differently from traditional bets, where the bet amount cannot influence the game, derivatives can. Let's take horse racing as an example. If everyone starts to bet on the worst horse, the bookies must lower the payout to the point there will be almost no payout for the bets. Why? Because they still price the remote, but not zero possibility, that the worst horse can win (imagine every other horse falls to the ground before the finishing line). The quantity of bets, though, will not make the worst horse neither faster nor stronger. In financial markets, the (gambling) logic above doesn't apply, why? Let's imagine an extreme case where a broker writes a put option on an unlisted company named DarioXYZ. The broker will not just sit on the risk since he cannot short DarioXYZ #stocks, but will hedge the risk "synthetically" shorting an asset. Let's imagine the broker picks $AAPL stocks. The broker then is supposed to borrow $AAPL stocks in a ratio they deem appropriate to hedge the delta for DarioXYZ private stock and sell them short in the market. This inherently will create selling pressure on $AAPL that is totally unrelated to DarioXYZ. At this point, you can intuitively understand that the hedging is far from perfect. Consequently, the broker will still carry a certain amount of risk in its books that cannot be hedged even. Unfortunately, I cannot quantify how much of that “hidden” risk is present nowadays in brokers' books, but by intuition, I can say that it is enormous. Now let's go back to the horse racing example. Instead of pricing the (very remote) risk that the worst horse can still win, a bookie accepts a huge amount of bets more than the capital he holds to pay all them out in case the horse wins. The bookie thinks everyone is an idiot and he already pictures the next yacht he is going to buy, but then the worst horse crosses the finish line first. What do you think happens next? The bookie is in default. Here is the trick though, the bookie can start collecting bets for the next race, and if the new bets come in faster than the previous winners coming at him to cash out, he can go away with declaring bankruptcy. If the bookie is very lucky and can repeat this perverse (and illegal) loop long enough with no more huge payouts, he can even get himself out of bankruptcy. Obviously, the key is no one knows how much capital he holds and how many bets he took. Otherwise, the winners will rush to collect their bets, the slow ones will remain empty-handed, and the bookie will go bust (and in jail). Does what I describe sound familiar? It is exactly what happened to Credit Suisse when Archegos went bust! No one knows how many losses are sitting in bank brokerages’ books right now, but everyone knows they are huge already due to US Treasuries, CRE, Real Estate delinquency, and so on. Still, these brokers keep taking bets in the market, trying to pull themselves out of insolvency (like the bookie). Cash is bleeding out of the system into money market funds and safe assets like T-Bills, but #stocks keep going up because everyone else is leveraged long and "extracting alpha" shorting ITM put options and going long calls forcing brokers to hedge in a way that “archegooses” those very same #stocks. With what just happened to the $JPY, a ton of liquidity just got pulled out from the system leaving many brokers hanging on a thread, and the prophecy of Warren Buffet might be very close to materialize.