FX

When currencies do not serve as a long-term store of value, economic actors search for ways to preserve future purchasing power, which often mean purchasing commodities. But most commodities are not cheaply storable over long periods, so actors get forced into the few that do: gold, silver, etc. There is a problem here, stemming from dumb money. When dumb money shows up for purchase of generic “commodities” distortions follow: backwardation, large storage demand, and warped market incentives.

Eventually overproduction catches up, but the volatility when it breaks can be huge and self-reinforcing, with c0unterparties raising margin to protect themselves.  Extreme volatility causes exchanges to raise margin requirements substantially, which reveals which side of the trade is inadequately financed, which typically is the side that was winning, which leads to a reversal in price action.  The dumb money is revealed.

Now after a washout, the dumb money often assumes that powerful entrenched interests colluded against them to deny them their long-deserved free ride to prosperity through speculation.  The exchanges are in cahoots with the other side.  Well, no, the exchanges have two interests, which are solvency and transaction volume, which drives their profits.  Solvency is a more primary goal for an exchange, because the second goal can’t exist without it, and exchanges are not thickly capitalized.

Many different types of financial systems are subject to these risks.  Think of AIG: they were rendered insolvent by rising margin requirements as their creditworthiness was downgraded, largely because the rating agencies concluded they were going to lose a lot of money off of their many bets on subprime residential credit.  Think of all of the mortgage REITs that got killed as repo haircuts rose on all manner of mortgage-backed securities at the time that values for the securities were depressed.  Alternatively, think of Buffett, who entered into derivative trades where he received money and bore the risk, but his agreements limited the margin that he would have to post.

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