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Swiss Currency Move Highlights Too Much Paper


Fiat currencies helped to intergrate economies, but their abuse has led to instability in markets.

There was little doubt that the Swiss were being forced to do something. After hinting at it for weeks, hoping that the markets would do their work for them (they never do), the Swiss National Bank announced a tentative peg for the Swiss franc to the euro. The announcement changed the direction of the franc, leading to significant losses for anyone caught betting against the fundamentally and perhaps fatally weaker euro.

The problems of the financial world, spilling into the real economy everywhere, are paper. And yet, every time a paper crisis re-appears the answer from every central bank is still more paper. Debasement and debauchery of every currency seems to be the new relative expression of "every currency for itself."

Therein lies the real problem. The global financial system is essentially predicated on two key words: seamless integration. The overall function of the financial system from continent to continent has grown up in the desire to easily and "seamlessly" promote financial flows to any market at any time. Entire generations of systems and theories were created to make sure this financial goal would be realized. And most of all, regulations were created, adjusted or plain set aside to foster the growth of this "efficient" monetary machine (see eurodollars).

Banks became true behemoths because international boundaries were no longer financial boundaries. Financial firms could obtain funding and promote matched books in almost any currency regardless of country of origin. The system was designed so that banks could be "in" every market simultaneously, effectively creating truly global institutions.

The inherent weakness of any system so finely calibrated is its low tolerance for error. All the recent trepidations within cross-border finance come from this requirement for stability; if not simple low volatility, then low second derivative volatility (if a currency pair is changing, that change must occur at a near-constant rate without significant risks for reversals).

European banks in particular, because of their history and proximity to the London base of the mammoth eurodollar pool, outgrew their respective home country economies through this dollar-denominated funding. So many dollars on the liability side of the balance sheet necessitates an intentional splurge on dollar-denominated assets. Since the Federal Reserve in the US was intent on inflating the US economy out of what it believed was a potentially deflationary episode (the dot-com bust) in the early part of the last decade, the willingness of global dollar participants to expand themselves was "fortuitous" for all parties. Domestic national governments all over the world looked the other way since they were all reaping the benefits of domiciling these financial giants and participating in their massive profits. Long range planning and risk management were completely left out of all this short-term success, leading to this hodgepodge of ad hoc short-term fixes to what is exactly an existential crisis.

The final piece to this artificial growth puzzle was relative currency stability. Predictability allows banks to predictably and efficiently hedge and match the tenor, rate risk and currency structure within their respective bank books. Stability is the grease to the mechanisms of the global monetary system. Instability brings not just chaos to credit production, but also massive costs and limited access to hedging – this was essentially the Panic of 2008.

In the wake of that crash, the global economy has suffered real economic damage. In so many cases, the damage has been so severe that the previous ideal of stability has been itself set aside. The terms of global monetary flows have been altered by a near-continuous state of interventions from one self-interested central bank to another (from Japan to the Fed to the European Central Bank). Without stability, hedging has become increasingly problematic, leading to mismatched books.

That is the likely reason behind the Swiss' latest move. They cannot suffer any more desperate inflows from investors seeking shelter away from the euro. Without exchange stability with both the dollar and euro, the big Swiss banks find themselves with proportionally too many Swiss franc liabilities. This tenuous situation imperils the solvency position of these banks. Too many dollar and euro assets mismatched by Swiss franc liabilities in an uncertain currency environment means technical insolvency is far too close for counterparty comfort.

The costs of hedging such volatility and uncertainty are mortally prohibitive, thus the "lower-cost" option of Swiss bank intervention. In this kind of dire strait, the potential loss from unknown exposure to billions of euros at the Swiss central bank is far more palatable than the potential insolvency of some of the biggest banks in the world. The situation has to be truly desperate if the Swiss are willingly courting not only devastating currency losses but massive inflation should the new franc reserves get loose upon their local economy.

No matter how one evaluates either of these options, they are both Faustian bargains of abnormal finance. While a currency peg sounds like stability, it is another layer of risk that takes the markets further away from the ideals of risk/reward. To put it simply, how much of investing today is based on fundamentals vs. how much is based on guessing what intervention is coming next and front-running it? This is no way to allocate capital, nor is it a pathway to stability since no one can even agree on the rules to the game anymore.

The salvation for the global banking system is essentially a removal of these abnormal financial constraints in favor of stability. Unfortunately, there is no simple method for reconciling intentional devaluations with burned investors, including the massive financial firms. Counterparty risk has been extended to currencies in an irreconcilable mess of miscalculated, self-interested interventions.

The age of fiat is approaching its predestined end because global integration was built on an artificial foundation. Everything appeared to work simply because all parties' goals were at one time in relative alignment. As it turns out, fiat currencies are simple expressions of nationalistic goals and conditions, making that foundation a temporary condition. Global integration is easily a casualty of local economic needs and the monetary mistakes those needs and pressures often produce.

Paper collateral has been the means by which the financial system manages all this integration, especially in the age of Basel rules. Mortgage bonds filled the bill when the system was multiplying on shadow leverage and central banks believed that the rapid expansion of credit was desirable. The collapse of that paper severely constrained global balance sheet capacity, herding the European system, in particular, into PIIGS as the only acceptable alternative of paper collateral. Again, Basel rules made it a certainty that the banking system would escape the mortgage-bond frying pan for the southern European sovereign debt fire.

The rumble of the stock market (SPY) (QQQ) in early August was an expression of global doubt about the larger issue of this breakdown in integrating collateral and the no longer seamless or efficient stream of modern finance through national borders. A desperate European system, mismatched with US dollar-denominated assets may have been forced to sell its most liquid class of those assets, such as US stock futures and US stock positions, when faced with this ongoing uncertainty of dollar funding compared with domiciled denomination. The inability to effectively fund and hedge has again led to asset price declines globally, in a fit of instability that perfectly describes a world awash in questionable paper.

The answer to the age of paper is an age without paper (at least without so much paper). The terms of exchange across borders is fatally flawed now that it is conducted under the auspices of fiat. The only effective, permanent solution is one that cannot be devalued or deflated by the whims of mathematical modeling or the winds of political considerations. Stability can be found in the barbarous relics of past global financial regimes, and their structures where mistrust of counterparty motives was open and integrated. Gold (GLD) and silver (SLV) were employed historically simply because they were predictable and universally accepted.

Today, precious metals are still relatively predictable outside of Wall Street's recent alchemies. Physical metal is physical metal. However, one must be careful of the potential of esoteric financial vehicles that are easily manipulated into other forms of still more paper positions, such as GLD and SLV, in favor of vehicles, such as Central Fund of Canada (CEF) or (GTU), or Sprott Funds (PSLV) or (PHYS), that hold actual metal. This misuse of gold and silver is yet another concurrent acknowledgment of so much of this recent turmoil; another example of the incurable dangers of intrinsically valueless paper and the extent to which humans will stretch the boundaries of faith in it.

The only piece missing for a precious metal solution to the financial turmoil is universal acceptance. That will take time to evolve, but more and more global participants are seeing past the artifice of fiat monetary regimes and demanding stability of exchange, especially vital collateral demands. The larger paper system is dying simply because humans will always be tempted to overextend in extremis in the absence of exogenous constraints – that is the essence of thousands of years of financial and monetary history. The paper system of global integration was abused because it could be, proving once again that this monetary age is no different. The demand for unassailable stability is growing as the rise in the prices of precious metals continually and forcefully proclaims the devaluation of almost every currency on earth. That the Swiss have joined this sad list is, in the light of history, not really surprising.

Editor's Note: For additional commentary, visit the website of Atlantic Capital Management.

Twitter: @AtlanticCapMgmt
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Position in CEF.

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