Dollar Status in Doubt After Washington Antics

10/17/2013 08:19 am 08:19:06 | Updated Jan 23, 2014

Whenever we see another case of manipulation in the currency, energy, gold, commodities, interest rate, credit derivatives, securitization, or equity markets, management of the culprit financial institution inevitably blames it on "unauthorized" trading by one or more "rogue" traders.

Traders' salaries are low relative to the potential for seven figure bonuses. When you offer a trader a pink slip for failure and a princely bonus for success, traders tend to minimize losses and inflate successes.

Traders can't make huge gains without having a huge source of funds to finance high-risk speculation. Thanks to the largesse of U.S. taxpayers and lax regulation at U.S. banks, we'll continue to see speculation and manipulation in all markets. Banks are "rogue trader" factories.

J.P. Morgan has recently been probed for a number of problems including the U.S. and British LIBOR-rigging scandal, the "London whale" credit derivatives losses, energy manipulation, mortgage loan origination, and foreclosure fraud. The bank is in the news again after hiring Richard Usher, a currency trader being probed for his activities at RBS, his former employer. No one has been accused of any wrongdoing in the ongoing investigation of potential alleged currency manipulation.

The Herstatt Effect

Bankhaus Herstatt of Cologne went belly-up in 1974 because of currency speculation. It wasn't a very large bank by today's standards, and it wasn't a key player in the global banking system. Yet it had a large foreign exchange business.

Herstatt failed to pay dollars owed to U.S. banks in foreign exchange transactions after the banks had already paid Deutsche marks owed to Herstatt. When some of Herstatt's unpaid trading partners subsequently reneged on payments to their customers, it set off a chain reaction. Transfers froze and the financial system came to a halt, in what we now call the "Herstatt effect."

This all happened on inter-bank transactions that appear tiny by today's standards. Relative to Herstatt's transactions, our too-big-to-fail international banks trade enormous size. Clearing banks commit so much capital to this activity that a failure could set off another chain reaction that threatens the global financial system. This is a relatively dark market where exposures are large and unpredictable. Since no one has a handle on the true size and distribution, the uncertainty has the capacity to intensify a financial shock.

"Knockout Options" and the Currency Crisis of 1994/5

George Soros reportedly lost $600 million on Valentine's Day in 1994, when he was caught on the wrong side of the Yen trade, after trade talks between the U.S. and Japan broke down. (Soros had made $1 billion just 18 months earlier when he bet against the British pound.) The previously falling yen reversed course and suddenly surged against the dollar. The Yen strengthened about 5% and then continued strengthening from around 102 yen to the dollar to around 80 yen to the dollar by April 1995. Currency derivatives played a major role in the dollar's steep slide.

Japanese banks and businesses hedged their dollar risk with knockout options. A knockout option gives the buyer the right to trade a set amount of currency at a set price for a specified period of time. It gets "knocked out," meaning the option is worthless, if you trip a pre-agreed trigger. In a currency knock-out option, the option is knocked out if the currency exchange rate hits a specific target. The possibility of knocking out the option entirely makes this hedge cheaper than a plain vanilla option. If a hedger sets the trigger so he feels the possibility of tripping it is remote, he thinks he's getting a bargain.

Many Japanese thought the dollar wouldn't fall below 95 yen per dollar, but the dollar plummeted even further than that and knocked out the value of the options. They panicked and dumped dollars, which caused a swift fall for the dollar. The big banks that played in the currency market in 1995 included Chase Manhattan (now part of JPMorgan Chase) and Deutsche Bank along with dozens of commercial banks. They also provided leverage to hedge funds, and it seemed that the Japanese bought most of these knock-out options from hedge funds.

Manipulation and Panic

Manipulation can cause a panic. One can manipulate all of the other financial instruments I mentioned earlier to blow out stops or other barriers. For currency knock-out options, you can manipulate currencies to hit the knock-out trigger. Knock-out options are just one example of many types of currency derivatives vulnerable to manipulation.

In an earlier commentary, I talked about manipulation in the gold and silver markets. Last week, there appeared to be blatant manipulation in the gold market. ZeroHedge reported that the CME went dark for 10 seconds after someone "banged the open" for gold.

In June, Bloomberg reported that traders at banks colluded to manipulate foreign exchange rates and had also been front running clients' orders. According to the June 13, 2013 report by Liam Vaughan, Gavin Finch, and Ambereen Choudhury:

"The manipulation occurred daily in the spot foreign exchange market and has been going on for at least a decade, affecting the value of funds and derivatives. The $4.7 trillion-a-day currency market, the biggest in the financial system, is also one of the least regulated."

Given what every financial professional knows about the destructive potential of currency manipulation, it's a national disgrace that U.S. banks are involved. In 17th century England, counterfeiting was high treason and the penalty was death. Today manipulating currencies earns the "penalty" of a less-than-scintillating coffee klatch at the White House.

Loss of Confidence Threatens the Dollar

The U.S. is facing a global crisis of confidence. The NSA's spying-on-world-leaders scandal, drone strikes killing Middle East civilians, ongoing banking scandals, and the recent Washington debt ceiling debacle that created a non-zero probability of a default on U.S. debt have brewed a crisis of confidence in the global role of the United States and the reserve currency status of the dollar. We may not see a sudden flight of capital from the United States, but we are increasing the odds that we will see a sudden fall in the dollar.

This commentary originally appeared at The Financial Report under the title: "Currency Manipulation and Derivatives."