Anatomy Of The End Game

Tyler Durden's picture

Authored by Martin Sibileau of 'A View From The Trenches' blog,

“…We cannot arbitrage fiat money, but we can repudiate the sovereign debt that backs it! And that repudiation will be the defining moment of this crisis…”

(click here to read this article in pdf format: November 22 2012)

About a month ago, in the third-quarter report of a Canadian global macro fund, its strategist made the interesting observation that “…Four ideas in particular have caught the fancy of economic policy makers and have been successfully sold to the public…” One of these ideas “…that has taken root, at least among the political and intellectual classes, is that one need not fear fiscal deficits and debt provided one has monetary sovereignty…”. This idea is currently growing, particularly after Obama’s re-election. But it was only after writing our last letter, on the revival of the Chicago Plan (as proposed in an IMF’ working paper), that we realized that the idea is morphing into another one among Keynesians: That because there cannot be a gold-to-US dollar arbitrage like in 1933, governments do indeed have the monetary sovereignty.

Is this true? Today’s letter will seek to show why it is not, and in the process, it will also describe the endgame for the current crisis. Without further ado…

After the fall of the KreditAnstalt in 1931, with the world living under the gold-exchange standard, depositors first in central Europe, and later in France and England, began to withdraw their deposits and buy gold, challenging the reserves of their respective central banks. The leverage that linked the balance sheet of each central bank had been provided by currency swaps, a novelty at the time, which had openly been denounced by Jacques Rueff. One by one, central banks were forced to leave the gold standard (i.e. devalue) until in 1933, it was the Fed’s turn. The story is well known and the reason this process was called an “arbitrage” is simply that there can never be one asset with two prices. In this case, gold had an “official”, government guaranteed price and a market price, in terms of fiat money (i.e. schillings, pounds, francs, US dollars). The consolidated balance sheets of the central bank, financial institutions and non-financial sector looked like this before the run:

And like this after the run:


Indeed, those who claim that today is different and make the dangerous case that “…one need not fear fiscal deficits and debt provided one has monetary sovereignty…” refer to this crucial difference in the balance sheet of the central banks then (i.e. in the ‘30s) and now:


And they are right: There cannot be any arbitrage, because there is no real asset to exchange fiat currency against. Only fiat vs. fiat (i.e. currency vs. government debt). But does this mean that the governments have monetary sovereignty? Does this mean there will not be an end game? I don’t think so. We cannot arbitrage fiat money, but we can repudiate the sovereign debt that backs it! And that repudiation will be the defining moment of this crisis. The key to understand how this will occur lies in focusing in the shadow banking system, rather than the banking system. In the universe of shadow banking we do not back fiat currency with real assets, but we provide sovereign debt as collateral to obtain the fiat currency necessary to establish positions in the commodities markets.

Some preliminary details

Our first assumption is therefore that the debt of the sovereign that issues the world’s reserve currency is repudiated. We can think of many events that would trigger that reaction: A monetary policy of the Fed that continues to enable fiscal deficits (something that already Jacques Rueff explained in the ‘30s) or the coming burst of the European Yankee market bubble (i.e. US dollar denominated debt issued by European corporations). Whatever the reason, the repudiation will have an impact in the repo market, which finances positions in the commodities markets.

Consider a trader in the commodities futures market. To finance his trading activity, he pledges collateral in the repo market, and receives cash. The collateral is often US sovereign debt and those supplying the cash in exchange for it are money market funds, under repurchase agreements. This secured financing entails the actual exchange of ownership, title on the collateral, which is “warehoused” in the balance sheet of the “lender”.

With the funds, the trader enters into a futures contract in the commodities market, but facing a central counterparty (clearinghouse). The trader has to post an initial and a maintenance margin. While the futures contract is in place, the trader (and his counterparty, the clearinghouse) will have an unrealized gain or a loss. As long as the contract is on, the trader will have to adjust the margin according to the gains or losses. At maturity of the contract, the trader can settle in cash or by delivery. At a consolidated level, however, there has to be a delivery of the commodity, at an auction, for the market (usually not higher than 1% of contract settlements). In the end, the trader must repurchase the collateral it had given to the money market funds, at a price equivalent to the principal plus accrued interest (i.e. repo rate). Below we show these steps in a chart, with real samples of how a hedge fund would show these transactions in its financial statements:


The End Game

Now that we are familiar with the steps above, think what would happen, if the US sovereign debt began to be repudiated, just like the debt of Italy or Spain. At the beginning, the repo rate (i.e. the interest rate charged by the money market funds) to lend to the commodity markets players would increase, making trading in commodities futures more onerous. Immediately after, however, liquidity would disappear as those investing in money market funds seek only short-term exposure with minimum risk. As well, given that most central banks hold US sovereign debt as reserves, one would expect an increase in global concern and a flight to safety in real assets.

With the rise in the cost of funding (i.e. repo rate) and the rise in commodity prices, it is to be expected that one trader short of a futures contract may suffer substantial losses. The increase in counterparty risk or the increase of a failure by a central counterparty (i.e. clearinghouse) would jump. And I think the jump would be so significant that even the delivery of physical commodities at auctions would be at risk.

The failure of a central counterparty is not new. In 1974, the Caisse de Liquidation failed on margin calls defaults associated with sugar futures contracts. In 1983, the Kuala Lumpur Commodities Clearinghouse crashed on palm oil futures and in 1987, the Hong Kong Futures Exchange clearinghouse failed also due to futures contracts, in equities.

Should a scenario like the above unfold, the Fed would likely be forced to intervene, inter-mediating between the money market funds and the commodities futures market. It could do so by issuing its own debt to money market funds (or any lender in the repo market) and using the proceeds to enter into repurchase agreements with traders in the commodities markets. The chart below illustrates this scenario:


Let’s take a close look at the balance sheet of the Fed, once it enters the repo market. A few observations are relevant:

a)      The Fed would now fund positions in the commodities markets

b)      Operationally, the Fed would probably mark the repoed Treasuries to model, not to market. Like the European Central Bank does today with Greek or Spanish bonds.

c)    The Fed would not “print” money. They would simply raise funds from the shadow banking system by issuing its own debt. Therefore, they would have to pay an interest rate high enough to entice money market funds to buy it.

d)     The Fed would not be able to “refuse” US Treasuries repoed. It would have to buy all the US Treasuries offered in repurchase agreements at their “marked-to-model” rate. But the money market funds could refuse to lend to the Fed, if a market rate is not offered.

And here is the catch, because in order to raise US dollars from the shadow banking system, the Fed would have to pay a higher rate than it would charge for its repurchase agreements. Otherwise, there would be no need to intervene the broken repo market, to start with!

And what would traders in the commodities markets do with the “cheap” financing provided by the Fed? Why, buy gold among other real assets!



This would constitute a much worse scenario, than the laughed at arbitrage that Keynesians so proudly say today is not possible, from fiat currency to gold.

Under this scenario, the rest of the world would get their hands on the reserves of central banks (i.e. US Treasuries) to dump them in the Fed’s balance sheet via the repo market and recycle the US dollars it obtains with money market funds, to receive Fed debt! (See chart below). In the process, the rate the Fed would have to pay to raise US dollars from the shadow banking system would have to spiral, sending a wave of bankruptcies across the US dollar zone, including the Yankee market. The Fed would be forced to increase its currency swaps and at the same time continue doing unlimited quantitative easing. The currency swaps would be extended to delay the inevitable defaults in global US dollar denominated bonds and the quantitative easing would be necessary because, given the high interest rates and defaults, even with austerirty, the fiscal deficits would continue, as tax revenues fall driven by the collapse of activity.

And now, the cherry on the top: How would the Fed cover its net interest losses, between its debt and the US Treasuries it would repo? By issuing currency!! This quasi fiscal deficit would lead us to double-digit inflation and if left unaddressed, would end in hyperinflation. The process would end when the US dollar loses its status as a global reserve currency, a status that the Fed would seek to defend at all costs, repoing Treasuries in the commodities futures markets.



Final comments

For the sake of intellectual honesty, I want to end this exercise laying out the main assumptions:

The first and foremost critical assumption is that there will be a repudiation of US sovereign debt. The second assumption is that this repudiation will break the repo market enhancing counterparty risk in those markets where the funding is sourced from the repo market. I think these two assumptions are reasonable and the spike in the price of gold to $1,900/oz was in my view triggered first by the speculation and later by the confirmation of the downgrade to AA+ of the US credit rating by Standard & Poor’s. It has also seemed very curious to me that since that moment, and in a very strange way, the gold market became more volatile, with violent triggered sales, on no relevant news (But this is pure speculation, only proper to myself, of course).

The third assumption is that the Fed would intervene in the way I suggest. And this, indeed, is more debatable. It is certainly not the only way the Fed could act. There are other “versions”, but this is the more likely in my opinion and others have led to the same results, in other countries at other times (refer for instance, the “Cuenta de Regulación Monetaria” implemented by Argentina in 1978, where the central bank paid a subsidy on interest-bearing deposits and cashed a penalty on chequing accounts). Also, bear in mind that if this scenario unfolded, nobody would want to take the other leg of the long futures contracts on commodities (for instance, by 1981, the central bank of Argentina had to absorb and finance a loss $5.1BN in foreign exchange swaps from failed counterparties, refer Communication “A” 31 (May 6th, 1981).  At the end of 1982, this loss was estimated at $10BN), converting the markets into a one-way ticket to high inflation: The link between forward rates, commodity prices and inflation expectations would be lethal!

Finally, the fact that US policymakers have been busy lately trying to regulate money market funds is to me an indication that I am not alone with these concerns. After a failed attempt by SEC Chairman Mary Schapiro to regulate money funds, on November 13th, the Financial Stability Oversight Council put forth new recommendations to regulate the industry. Of course, some of these recommendations (see “minimum balance at risk”, on page 6 of the document) do not apply to Treasury money market funds, because US sovereign debt is not risky, right?

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FoolsAdvice's picture

Be humble in your thankfulness today.

GetZeeGold's picture



It's a 106 miles to the endgame, we've got a full tank of gas, a half a pack of cigarettes. we're thankful, it's dark, and we're wearing sunglasses.........HIT IT!

EnslavethechildrenforBen's picture

Endgame is when we the people are homeless, jobless, out of gas and with nothing to eat. Coming to your neighborhood soon. The criminals are enjoying watching us squabble for scraps from their mega yachts and private islands. They should be thankful the sheeple haven't woken up yet.

blunderdog's picture

Nah, that's just the START of the parallel society which'll be in competition with the government monopolies on "law."

There are tent-cities all over the US already.  It's worth looking at how a group of refugees like the Occupy yer Ass crew feeds themselves--it'll be handy to know if you find yourself joining the huddled masses someday.

Never One Roach's picture

You just reminded me; it's almost end oif year record high bank bonus time. I wonder if these massive perks will be posted soemwhere?

old naughty's picture

Well, time to balance those T Accounts...No ?

BLOTTO's picture

Both J.F.K. and A. Huxely died today.


November 22nd.


duo's picture

note that the live oaks have grown to obscure the path of the fist shot.

BLOTTO's picture

Woops...double-post...double trouble.


Im baked.


overmedicatedundersexed's picture

the empty stomachs of the poor is the sword of God...those that rape the people, the 1%, who grow richer and more powerful- it will turn to dust in your mouths. 

THE FRN is debt owed the FED..the pols (.gov) think in the end they can default on the nations debt..the get out of jail free card.

what then changes? that my friends is unk. for so much is interlinked from 401K's to central banks assets across the globe..someone will be very unhappy perhaps many someones.

I hope many on ZH understand the USA has had many forms of money over our history, from silver and gold certs to treasury notes, bank notes....why could that not happen again? China knows it can.

Disenchanted's picture



Quote below from:

From Fantasy To Fact: Four Ways The Fake Media Creates A False Reality


The latest mantra that the mainstream media is using in a domestic context is the "fiscal cliff." Media messengers for the tyrannical establishment do not discuss how the Federal Reserve's private money machine, Wall Street bailouts, and the military-industrial complex's wars have caused the skyrocketing of U.S. debt. They just keep repeating "fiscal cliff," and then offer bipartisan solutions that will benefit the banksters in power while destroying the living standards of middle class taxpayers and workers.

By focusing on the "fiscal cliff," rather than the Grand Canyon of Deception that is the unconstitutional Federal Reserve system, the mainstream media legitimizes the looting and pillaging of the American people by the transnational banksters.



Fiat justitia ruat caelum
EnslavethechildrenforBen's picture

If any single country went on the Gold Standard today, all the other criminals paper would be worthless tomorrow. Clearly all the criminals are on the same team

MillionDollarBoner_'s picture

...and who is the biggest accumulator of PMs in the world today?!?

Go figure ;o)

Debt-Is-Not-Money's picture

"...why could that not happen again?"

Because it would take someone in authority having the knowledge, brains, balls and who has the best interests of the Country and it's people at heart.

Are we fucked or what?

Happy Thanksgiving, maybe next year!

SheepDog-One's picture

In short, you can do whatever you want, people apparently like being debt slaves.

bonderøven-farm ass's picture

"It's hard to free fools from the chains they revere....." ~ Voltaire

FeralSerf's picture

It isn't a matter of liking, (or not) being debt slaves.  The "People" know nothing else.  This is by design.  They have been conditioned, educated by the public school system and MSM, brain-washed to know nothing else.

Do a poll amongst the ordinary people that you come in contact with.  Ask them what "Note" means in "Federal Reserve Note" or "This Note is Legal Tender for All Debts Public and Private".  I would bet that much less than half of them recognize that "note" in this context means a debt of the Federal Reserve.

unrulian's picture

They still wouldn't know what that means

Jafo's picture

Does it really matter whether it is the Fed that fumbles it or the politicians that fumble it?  The more that the Fed and/or the ECB juggles the more likely it is that something is going to be fumbled.  At some point someone is going to fumble it and that is when the systemic reset occurs.  That point is getting closer and closer.

Winston Churchill's picture

Whole lot of plates up in the air right now, and the jugglers are getting tired.

White and Black swans flocking prior to arrival.

The turkey in the White House doesn't help either.

Happy metaphor day.

TruthHunter's picture

"The turkey in the White House doesn't help either."

Yeah, whats with this yearly turkey reprieve? Some celebrity turkey gets to

to live, while plebiean turkey gets served on the table?


They don't call it Turkey Auschwitz day for nothing!


Oh, you were talking about Obama? Never mind the edit, same sentiment works!

doomandbloom's picture

waiting for banzai's version

overmedicatedundersexed's picture

the next NEW money is here now and it's plastic..will the tax units accept bet: those welfare benefits plastic cards are" like money man"..obuma bucks. the coins and paper FRN's we knew are soon gone. will PM's still have value? each card will start with the number 666.

akak's picture

I was talking to my local bank manager yesterday, and she told me that traveler's checks are apparently now history, and no longer available ---- oh, and also that there is talk in the banking industry of charging customers fees for engaging in ANY form of physical cash transaction.  Welcome to the Borg Collective ...

EnslavethechildrenforBen's picture

Precious Metals have absolutely no value at all. Period.

I'll be happy to take them off your hands for nothing so you won't have to pay someone to haul them to the dumps


ebworthen's picture


Look for the end of physical currency (bills and coins) much sooner than you would think possible.

Everything forcefully locked into a bank account, track-able and taxable down to the last penny.

Banks charging fees and a % cut for the privilege of them holding your money.

Overfed's picture

Picture if you will that scenario coupled with upward rocketing food and fuel costs. A new combination debit/credit card comes out that gives that gives it's use a little "leeway" to run up debt when the bank account is empty. It's a whole new play on owing your soul to the company store.

andrewp111's picture

Once  they eliminate currency and coins, they will give money a "color" as a form of rationing to prevent hyperinflation. Food can only be purchased with food stamps, only rent credits can be used for rent, gas credits for gas, etc... and it will be global. Only the central bank cartel moneychangers will be able to convert one flavor of money to another, with heavy restrictions and a heavy cut for TPTB.  The full global "mark of the beast" digital currency will last for 3 years and 7 months before all hell will break loose.

Stuntgirl's picture

Spain just illegalised cash payments over 2500€, yet no accompanying law regulating how much banks can charge for transfers was even discussed.

Meanwhile, the new Euro notes security measures were presented a few weeks ago. Old (???) Euros will be substituted for these new notes starting next year. Not all notes at the same time, for now, the lowest denomination, the 5€. It'll be interesting to see in terms of units issued.

buzzsaw99's picture

absurd premise and microscopic result-view. if mountainous meteorite, then commodity markets roiled. farce.

THE DORK OF CORK's picture

A treasuary can just issue (taxable) central bank needed.


However it will have no call on resourses beyond its own political bounderies.

Oil does change many things.

Abe Lincoln essentially used domestic coal and turned it into raw currency which held its power.

EnslavethechildrenforBen's picture

Paper backed by chicken eggs, tomatoe seeds, 3/4" gravel, anything would be better than paper backed by thin air

FeralSerf's picture

". . . tomatoe . . ."

Dan Quayle, is that you?  Long time, no see!

woggie's picture

the beast is on the gobble and all that matters is we're all headed for it's belly

rsnoble's picture

Fuck it im just a rat in a cage im gona eat turkey and drink beer all day.

Diesel Seven's picture

Good article. Too many PHD economists and politicians skipped the first paragraph of their high school econ texts . . . where economics is defined as the "science" of the efficient allocation of scarce resources. On a macro sense, fiat may be controlled, but it is not scarce. Commodities are the scarce resources that are the constraint to the sustainability of current economic policy.

lieto's picture

Ratings are garbage, throw them out with the turkey carass.

Real things are the only things that are really AAA starting with gold.

Paper and derivitives will do us in.

God help us.

Happy Thanksgiving to all at Zero Hedge.

JustObserving's picture

Rich nations have arrogated the power to issue ratings.  Then they rate themselves highly lowering borrowing costs and developing countries lowly, imposing a tax on them.  It is theft from the poor to the rich - but that is the organizing principle of the world economy today.

Dagong rates USA as A, the same level as Russia or South Africa.  But, of course, Western nations will not recognize Chinese or Indian or Brazilian rating agencies - it will be an abrogation of Western power to loot developing countries.

Interestingly, Dagong claims that the size of US economy is padded up by fake financialization:

"In addition, due to the high economic financialization, more than half of the profits in the real economy come from the returns of financial activities. If we exclude the factor of virtual economy, the U.S. actual GDP is about 5 trillion U.S. dollars in 2009, per capita GDP about $ 15,000."


Shevva's picture

You know your funked when, food stamps>dollars.

Back of the line paper boy.

Diesel Seven's picture

One last thought for this US Thanksgiving day: a study conducted by the College of Domesticated Animal Culinary Science found the 97.64% of cats found in the homes of deceased owners fed on their owner's corpse. Enjoy your turkey and beware of your cat.

gjp's picture

The 'market' will not reach its end game through the internal shenanigans of the financial players / central bank with repos and derivatives etc. ... the end game will only be wrought when society repudiates the currency and nobody takes the paper anymore.  Hard to imagine that happening, and that's why the 1% can squeeze so much through their control of fiat, but it's not limitless, and the exponential path fiat is on leads me to believe the US dollar system won't make it to 2015 in its current form.

Confundido's picture

True, but the society will start repudiating when they see the cost of food and other commodities spiralling. The post explains one of the ways that can happen. Once it happens, what you have in mind will happen.

agNau's picture

That would be "Dollar crises and plan to extend it" honorable Harken.

Hope they pass it soon, so we may see what's in it!

Give thanks today for what you had.

RobD's picture

Hmmm I knew the door that Chief Justice Roberts opened would be exploited. Another mandate(i.e. tax) that you have to pay. Fucking thieves.

Urban Redneck's picture


Harkin aint honorable.

He wants an even bigger "lock box" to pick and he wants to pay banksters big bucks to do so.

Furthermore, he fails to even mention that ZIRP destroys risk appropriate pension investment options, and consequently would do nothing but create another fraudulent state sanctioned PONZI scheme.

What is beyond disingenuous, to the point of kleptocratic, is the intentional conflation of the second and third. IRAs and 401(k)s are NOT pensions, they are SAVINGS. 

Here in Switzerland, the three pillar pension system is law and functions, and it makes Harkin's broken three-legged stool analogy seem apt and humorous.  However, his implied sacrifice of personal savings and wealth to prop up a failed government and failed financial services providers is anything but humorous.

Harkin aint honorable.   Neither is his family.   Neither is anyone who works for him.


RockyRacoon's picture

From the Harken "plan"....  I smell a rat.  A big, slobbering, mean, trecherous rat:

Over the past two years, the Senate Committee on Health, Education, Labor and Pensions
has held a series of hearings on the retirement system.18 The hearings have taken a hard look
at key aspects of the retirement system, and they have provided a clear picture of the kinds of
changes we need to ensure the system can work for everyone. Those changes can be boiled
down into the following four basic principles:
1. The retirement system should be universal and automatic.
Most people realize that they should be preparing for retirement, but it is often difficult
because they have more immediate concerns, like paying the bills and putting food on
the table. And people are frequently overwhelmed by the complexity of the financial
decisions they have to make.19 However, when saving is easy and automatic, people are
much more likely to put money aside.20 By ensuring that every American has access
to a retirement plan at work and making participation automatic, we can drastically
reduce the retirement income deficit and promote retirement security.
2. The retirement system should give people certainty.
The retirement system should give people certainty that they will have a reliable source
of income in retirement. It needs to provide people with the opportunity not just to
save for retirement but also to secure a predictable stream of retirement income that
they cannot outlive.
3. Retirement is a shared responsibility.
Individuals, employers, and the government all have a role to play in ensuring that
every American has the opportunity to retire with dignity and financial independence.
It is unfair for any one party to shoulder the burden alone.
4. Retirement assets should be pooled and professionally managed.
The retirement system should not force people to become investment experts. Most
people simply do not have the background, interest, or time to manage their retirement
funds effectively. Instead, it should give everyone access to prudent, professional asset
management and allow people to pool their assets with others to reduce costs and risk,
including the risk of living longer than expected.
These four principles should form the framework for developing comprehensive solutions
to the retirement crisis. With a retirement income deficit of $6.6 trillion, the crisis is simply
too big to ignore. We cannot continue to stand idly by as average Americans struggle to save
for retirement and our seniors continue to slip into poverty.