More Derivatives Trading Now In The 'Shadows'

Includes: IYF
by: John M. Mason

Gillian Tett of the Financial Times, in her review of where we are where we are five years after the financial meltdown writes:

"The shadow banking world is taking over more activity, not less. When Lehman failed, regulators suddenly realized they had been ignoring the non-bank sphere, enabling egregious behavior to flourish. Given that, you might have expected those shadows to shrink. But think again: it has expanded since 2008 from $59 trillion in size to $67 trillion, according to the Financial Stability Board. And it is likely to swell further, because tighter bank regulations are pushing more and more activity into the non-bank world. The FSB insists it has become better at monitoring these shadows; we had all better hope it is right."

To give this more specificity, Patrick Jenkins and Daniel Schäfer write that "shadow banks, such as hedge funds and other non-bank financial institutions, (ARE) now taking more than 50 percent of both interest rates and forex trading for the first time, according to data from the Bank of International Settlements." This quote is also from the Financial Times.

What is taking place is that more and more transactions are "bilateral over-the-counter deals on exchanges where pricing is more transparent."

Jenkins and Schäfer go on to quote one (unidentified) investment banking chief who says that "There's been a substantial increase in the number of small banks and hedge funds operating in this space. That has helped to narrow spreads, which is good news for clients ..."

The overall numbers on the market: interest rate volumes are up more than one-third since April 2007 and up ten percent since April 2010. Forex trading has risen by nearly one third in the past three years and has risen by more than sixty percent since 2007.

But the banks that formerly controlled the business have seen their revenues decline in both the interest rate area and the forex area.

Furthermore, the City of London is taking on more and more of this business. The Bank of International Settlements has reported that forty to fifty percent of all foreign exchange and off-exchange derivatives trading is now going through London.

It is just a wonder, to me, why anyone should be surprised by this. Given the information technology that exists today exists in the world today, almost anything can be done by almost anybody … almost anywhere.

I have been writing since the summer of 2009 that there is very little way that governments or regulators are going to be able to keep up with what is going on in the financial sector when it comes to doing business.

Finance is nothing more than information … it is just zeros and ones! Information can be sliced and diced almost anyway one wants to cut it. Information is available almost anywhere in the world … instantaneously. And, one does not need massive scale in terms of computer equipment in order to be a player.

As the U.S. government began putting together the Dodd-Frank Wall Street Reform and Consumer Protection Act I was arguing that in terms of financial regulation the government always fought the last war. I continually suggested that as far as the effectiveness of the act was concerned the financial system was already far ahead of what the Congress was trying to do.

And, what results do we see over and over again? The big banks have gotten larger over time and in the United States the largest 25 domestically chartered commercial banks in the country now absorb roughly 55 percent of the bank assets in the country. Foreign-related depository institutions take up another 17 percent. Thus, 82 percent of the assets in the banking industry are in primarily in very large financial institutions.

Furthermore, as is seen in the numbers presented earlier, the "shadow" banking system is growing by leaps and bounds! Right now, there is little or nothing that can be done to stop the movement. There is little regulation in these "shadows" and, as should be obvious by now, the "shadows" move as the environment changes.

And, as many others are now arguing, the things that the governments have done over the past five years or so have just helped the wealthy get wealthier … as most of the date being released on income/wealth distribution now confirm.

To me, this is the path to the future. Alternative financial institutions or financial processes, like peer-to-peer lending, are going to continue to become a larger and larger part of the financial scene. This will make it harder and harder for the government to effectively regulate the financial system. And, it will make it harder and harder for the Federal Reserve to get the results it wants from its monetary policy.

And, the one factor that allows all this to happen is information technology and the advancements that take place in this field. Whether or not you like it … that is the way it is going to be.

My suggestion is to go with the flow and find out where you can benefit from the incredible changes that are taking place in our world and in the opportunities that the government and the Federal Reserve create for us in trying to fight the last war. Over the past five years I have tried, in writing this blog, to point out where some of these opportunities might lie. But, if you look, I am sure that you can find a number of them yourself.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.