Why "Margin Debt" Is Meaningless In The New Shadow Banking Normal

Tyler Durden's picture

Everyone who has followed this website since 2009 will know that we firmly believe that the "magic plumbing" of the modern financial system is not what is seen on the surface, in terms of declared "on the books" assets and liabilities, but what happens beneath it - in the shadow banking system, a place where trillions in liabilities are created and destroyed via the repo market, to provide short-term funding for all sorts of financial intermediaries, frequently with zero actual exposure in bank Ks and Qs due to regulatory loopholes that allow the "netting" of hundreds of billions of offsetting repo exposure and keeping them off the books, exposure which than can be rehypothecated countless numbers of times. In theory, this works fine. In practice, when a collateral chain is broken and net suddenly becomes gross, you end up with near systemic collapse (especially when the underlying collateral is found to have never existed in the first place - see China).

This is precisely what happened following the failure of Lehman when in addition to all other credit risks, maturity, credit and liquidity, one also had to add counterparty risk. Suddenly, the realization that any and every bank can fail caused a sudden and epic rush on repo, in the process truncating collateral chains and smashing the velocity of collateral. This is also why the Fed had to step in and take over virtually the entire financial system: after all the Fed can't fail, or so the conventional wisdom goes. And with this backstop in place, the US financial system has been moving slowly since 2009, as counterparty risk has never been mitigated, In fact, for all its confusion, the Fed doesn't realize that because it has onboarded countarparty risk exposure as one of its primary functions, there is no hope that a return to normalcy will ever be achieved. In brief: counterparty risk - one where the overnight funding market may freeze up at any given moment in a world without the Fed - is now a staple of the financial system. It also explains why the Fed will never be able to exit the market, as the second it does there will be sweeping repo runs of the kind that crushed Lehman and the money market system in 2008.

Long-winded introduction aside, the reason why bring up the repo market is because in recent years there has been much attention on one specific metric: securities margin debt as reported monthly by the NYSE, and which recently peaked at a record $465 billion. Some look at margin debt as an indication of how stretched investors are and further point to record margin debt peaks as inflection points in the market as the likelihood of margin calls surges and even the smallest drop in asset prices can result in an avalanche of liquidations and a self-fulfilling prophecy of selling.

In theory (again) this is correct. In practice (again) this is very much an anachronism of what the market used to look like. Unfortunately, in the New Normal, NYSE margin debt is completely useless in demonstrating just how stretched investors, especially sophisticated investors like hedge funds are (which in a day and age when retail has thrown in the towel on the manipulated, rigged market, are all the matters).

So where should one look for hints on the true leverage of market participants? Why the shadow banking system of course, and the repo market in particular.

Luckily, since the topic of shadow banking is quite complicated (virtually none of the regulators, auditors, enforcers or even central-bankers understand its nuances), one of the most erudite sources on the repo market, the IMF's Manmohan Singh, has just released his annual primer on shadow banking, this time titled "Financial Plumbing and Monetary Policy" which touches on all the salient points we have covered in the past several years: offsetting shadow banking liability contraction, the Fed's Reverse Repo initiative, collateral velocity, the ZLB impact on unsecured overnight funding markets, and high quality assets. It is a worthy read for anyone curious about how the financial system really works because we firmly believe that Singh along with Zoltan Pozsar, Peter Stella and Citi's Matt King are some of the very few people who actually "get it."

But aside from his extensive discussion on the intricacies of how funding works in a New Normal which has been mangled beyond recognition by central banks, Singh has a Box aside on precisely the topic at hand: how hedge funds fund themselves, and why margin debt is completely irrelevant in a world in which funding needs are provided not by the exchange itself but by other interconnected financial intermediaries mostly Prime Brokers: a process which is preferred furthermore because the net exposure never has to be revealed to either bank shareholders or hedge fund LPs.

This is what Singh has to say about how hedge funds operate in repo space:

Hedge Funds (HF) largely finance their positions by either (i) pledging collateral to prime brokers (PB) to borrow money, or (ii) repurchase agreements (or repo) with either their PB or another dealer where the repo their collateral for funding. This box estimates the repo financing by HF with the key banks active in collateral markets, as of end-2007 and end-2013.


To estimate repo related collateral from HF for 2007, we take the assets under management (AUM) of $2 trillion and the 27 percent share of strategies that would use repo (i.e., primarily non-equity related strategies). Aggregate leverage is higher in fixed income, global macro strategies that are funded via repo relative to equity type strategies. Using the aggregate leverage of 4 (source FSA hedge fund surveys, United Kingdom), this would imply that approx US$540 billion times four or, US$2.2 trillion pledged collateral could have gone to the banks. However, about 60–70 percent of the strategies are hedged simultaneously so only one-third of US$2.2 trillion could reach the banks that can be re-pledged onwards—i.e., US$750 billion pledged collateral that came to the banks could be re-used onwards as of end-2007.


On the 60–70 percent threshold assumption—at the bottom of the rate cycle, there is more hedging so this threshold is higher when compared to top of the rate cycle. In other words, the threshold prior to Lehman’s demise maybe closer to 60 percent and thus more pledged collateral available (i.e., less simultaneous hedging) to the dealers. Present times are close to the bottom of the rate cycle; so threshold may now be over 70 percent (i.e., more simultaneous hedging) and thus, less pledged collateral for reuse passes to the dealers. Doing similar arithmetic for end-2013, with aggregate leverage, including derivative use, lower at 3.5 (relative to end-2007) but AUM much higher at US$2.6 trillion, and share of HF strategies using repo also higher (around 40 percent) relative to 2007, would put the estimate at US$900 billion (adjusted downward due to the higher threshold for hedging due to the bottom rate cycle). With collateral reuse factor between 2 and 3 (largely due to inter-dealer collateral moves that link the supply/demand collateral chain), the size of the bilateral global repo market is at par or larger than the TPR (tri-party repo) in the U.S. [although HFs play a  dominant role in bilateral repo, dealers also use collateral from primary issuance to cover shorts in their repo inventory].


To be technical, if about two-third strategies are hedged, the collateral from the remaining one-third may not all be reused/turned to cash by the banks—it depends on their balance sheet space and this issue is getting more traction as proposed regulations will take affect going forward. Also, banks can be very different with UBS bank curtailing balance sheet activities in pledged collateral area while others trying to enter this market.


In short, when it comes to funding, the most sophisticated market participants, hedge funds, have zero use for conventional cash exposure such as exchange margin, which is well below half a trillion, and instead obtain at least half of their funding needs in the shadow market via repo, to the tune of about $1 trillion (and likely more depending on one's assumption about collateral reuse).

Which is why the next time someone says to pay attention to market leverage and points out the NYSE margin debt, feel free to correct them that this accounts for a tiny fraction of the overall leverage involved in the market - almost exclusively that attributed to retail investors who, as we know barely exist. For a real representation of market leverage one has to evaluate just how much repo funding the shadow banking system has afforded to hedge funds. Sadly, since there is no regulatory required reporting framework for disclosing this information on a consistent basis, one is largely stuck estimating what true leverage in the market is.

Actually, there is one loophole. As we showed in April, once a year hedge funds update their annual Form ARDs to show not only their net assets, which exclude shadow banking liquidity, but all regulatory assets, which capture all forms of funding.

For all those curious, here is where the hedge fund world truly stands when accounting for all sources of funding, in the current market. We leave it up to readers to decide if leverage as high as 9.3x is "high."

And the change overtime:

It is mostly here where the largely undocumented credit unwind will take place once the relentless bubble finally pops, and to be sure, nobody will have possibly been able to see it coming.

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
Mr_Wonderful's picture
Press Release - Secret Trade in Services Agreement (TISA) - Financial Services Annex 2014-06-19



Cthonic's picture

One step closer to one world financial jurisdiction.  Used to be able to 'vote with your feet' in the US, by moving to another state.  Now you won't even be able to vote with your feet by moving to another country.  Perpetually indentured, to the new world order.

SafelyGraze's picture

"clearing" is the term for when someone is willing to recognize your bag of fairy farts as the real thing, not some sort of sham counterfeit

thereby allowing those fairy farts to do their job of being exchanged for real pixie dust and emperors-new-clothes

as long as individuals in the surveillance-military-defense-education-energy-lawEnforcement-industrialFarming complex continue to accept ("clear") pixie dust as payment, the fairy-fart plumbing is demonstrated to be perfectly legit 



Groundhog Day's picture

So little old me beats out their performance using no leverage at all.  Maybe I'll charge myself 2 and 20

ebworthen's picture

"Derivative" and "Swap" are interchangeable with 60X leveraged dark pools of immorality.

What these Harpies and Warlocks really leverage are other people's lives.

skbull44's picture

I am reminded of a quote by the late Michael Ruppert in the documentary Collapse:

" We live in an infinite growth paradigm which requires growth forever. It's not that Bernie Madoff was a pyramid scheme...the whole economy is a pyramid scheme, the whole global economy cannot be sustained. It requires infinite growth, but infinite growth collides with finite energy.
The first law of thermodynamics says that energy can neither be created nor destroyed. It can only be transferred from one form to another...You have finite energy and you have a financial paradigm which demands infinite growth and we are at a point in human history where the infinite growth paradigm collides with something that is more powerful than money is.
The people who have run the planet to this point and are running the planet now are losing control. What I see is a new paradigm that is as cataclysmic as the asteroid event that killed almost all life on the planet and certainly the dinosaurs. We may be seven billion people by the time anyone sees this interview. All of those people exist, are on this planet only because of oil. That's it. So it's axiomatic that if you take the oil away, the population must go away also.
Certain things are inevitable right now. FDIC insolvency I will tell you is coming. Insolvency of the Federal Reserve is coming. The Federal Reserve can go bankrupt. T-Bill defaults. We're looking at major bankruptcies, starvation, dislocation, all these things are already on the way. Everything is going to breakdown."


ebworthen's picture

I had business students in a class I taught raise their hands and say that consumption was all there was and the goal of any business was perpetual growth.

NOTaREALmerican's picture

Oddly enough tho, they are right.   Any yeast bacteria would agree.

The Econ Ideal's picture

Yes, and the second law of thermodynamics has plenty to say about perpetual motion machines. Ponzi schemes and Ponzi finance are peddled out on a grand scale, and couched as normally functioning markets. 

NoDebt's picture

9.3X leverage ratios? Oh, holy cow, I read that whole article and figured the punchline would be something like 80X (or 800X) leverage or something.  Glad it's only 9.3X.  Whew.

I hate it when authors scare the pee outta me like that over nothing.

Winston Churchill's picture

9.3X to X 42 times if we follow the example of control fraud at Bear Stearns.

We are one loud fart away from a SBS stampede for the exits.

sodbuster's picture

Yeah- but they are hedged- and everyone knows hedges are good as gold. >sarc<

LawsofPhysics's picture

Collateral?!?!  What's that?

Nothing that you can really say except this is what you get when you put stupid motherfucking paper-pushing fucks in charge...


Kirk2NCC1701's picture

Yup, the ultimate game of Monopoly.  On the grandest scale possible.

Those who become Kings of Tertiary Wealth, can use it to acquire Primary and Secondary wealth.  And that's exactly what they're doing:  Stealing the world for pennies.  While the distractions of sports, scandals and wars are being played.  Dumb fucking sheeple!

p.s. How are those guillotines or dull axes coming along?  Or an American Spring?  [crickets]

NotApplicable's picture

Why it's the integral used to derive the velocity, rehypothetically speaking.

As far as collateral having "velocity," who knew?

NOTaREALmerican's picture

Good article.    No conspiracies.    Just the smart-n-savvy people maximize their winnings.

Kirk2NCC1701's picture

If this were an American football game, you keep running successful plays until the Defense stops you.

What's amazing isn't the skill of the Offense, but its absence from the Defense.  The US is so screwed.  Or will be, when the rest of the world gets so fed up getting screwed over, that they dump the Petrodollar. 

TPTB are doing everything they can to delay that inevitability, to maximize the time for acquiring Primary and Secondary assets around the world.  Get ready for Feudalism 2.0, sheeple.

p.s. If you're still wondering why other Western countries aren't revolting against the Fed's fiat Ponzi, it's because their Elite are playing the same Neo-Feudal game of Acquisition/Monopoly as are our NWO Neocons.  No global conspiracy is needed, even if it does exist in some circles, because: Never attribute to malice that which can be adequately explained by self-interest + ambition.  IOW... Motive + Means + Opportunity = Results, still works.  Whether the "Results" are honorable or not.  Same for "team work", "collaboration" and "collusion".  These work at all socio-economic levels.  It's just that the 1% and the 0.01% are in much better position to leverage + execute on their own and joint plans, than do the rest.

pps.  And before you/anyone creams their jeans about these 1% being "smart-n-savvy", remember that their "smarts" lie in the fact that they positioned themselves into the right place at the right time.  They are "savvy" insofar they've leveraged their advantageous position for amplified ROIs.  But what they're amplifying is not their innate brain power, or to work 20,000 hrs/day to create things (Secondary wealth).  They are simply playing The Game (that they created), to amass Tertiary (paper) wealth.  Pity that the 99% either haven't seen through it -- or are too fat, dumb, lazy, scared or disorganized to do anything about it.  Oh well, same as it ever was.  Same as it ever was.

NOTaREALmerican's picture

+10.   Good summary of things.

LawsofPhysics's picture

Correct!  I'd also argue that it's when the "game" changes that you really see who the smart and savvy people are.

Case in point, the last time the game changed significantly was in 1913, the Rothschilds were "well positioned"...

what&#039;s that smell's picture

in the shadow world, there is shadow collateral, shadow deals, and shadow contracts.

how in the blasted name of baalzebub can the author of this article make any assertions about the shadow world?

...and how such a murky unknowable world might affect the "real" world up here in the light?

the shadow banking system is as opaque as the inner workings of the NSA or any drug cartel or the State Dept's battle plans for the middle east.

"i hear unicorns have one horn." 


NotApplicable's picture

Here, let me bold this part for you.

Actually, there is one loophole. As we showed in April, once a year hedge funds update their annual Form ARDs to show not only their net assets, which exclude shadow banking liquidity, but all regulatory assets, which capture all forms of funding.

buzzsaw99's picture

in a zirp 4evah world that strategy makes perfect sense

OC Sure's picture

So then the insta-credit from the Fed for QE hits the primary dealer's "balance" sheet, then the primary dealer does a reverse repo (they give cash back to fed for the "collateral" of holding the repo agreement as a security), then the hedgefund borrows from the primary dealer? Is that the chain of events or I am wrong?

Here is the rise in Reverse Repos according to the Fed:


madbraz's picture

Spot on. And they get paid by the NY FED to take collateral and repo it to whoever they want and/or use the collateral to "short" the same treasuries and help the NY FED "try" to influence even long term interest rates (higher, so risk up).

There are claims that this "collateral" cannot be used to cover shorts. But what about just posting it as collateral for the short, doubtful they don't use it for that purpose.

In securities lending, banks pay the Fed to borrow treasuries. In Reverse repos, they PAY banks to borrow treasuries. Makes sense, right?

OC Sure's picture

I see. Thanks.

Can you, or someone answer this too? Then the "collateral" of the repo is used multiple times to "secure" several unrelated loans all at once? Is that right and thats what causes all the leverage? Or, could it just be said that whether they claim that 10x loans are tied to one chunk of collateral or that 10x loans are each 1 by 1(all the way up to 10) tied to an individual chunk of collateral that can each cover the loan if it defaults doesn't matter because either way the presto-loans are all originated out of thin air and the entire process is devised just to give the illusion that something is being generated from something when instead it is the attempt to generate something from nothing?  

madbraz's picture

I can't confirm or pretend to know any of this for certain - I am just trying to decipher what the hell goes on, looking from the outside in and trying to interpret based on common sense.  Even the NY FED pretends not to know what is going on in this market and makes pathetic arguments to justify its involvement (reverse repos).  Mouths are shut, it seems like, by design.


It makes no sense - to me it is the perpetuation of criminal behavior to keep their game on.  


Think about it, the NY FED encourages players to "rent" collateral from them to support trillions in leveraged, unsecured lending, in the process paying them interest to do so.  Who tells them to do this?  The primary dealers who own the NY FED.  The primary dealers who sell the collateral to the NY FED.


If they continue this stupidity, if we have a black swan you could see negative interest rates on long bonds.  No kidding.  Exactly the opposite of what the players want.







NickVegas's picture

"Where the overnight funding market may freeze up at any given moment in a world without the Fed."

It's MAD I tell you, madness.


I saw all of this manifesting since March 10th 2008 @ 11:00am

Bear Stearns time. I knew Lehman Bros. was going down at the same time. Why in hell should I believe that others much more capable did not see this coming down the pike? Clearly, KPMG

Chatered Accountants must have ssen this brewing when they

certified Iceland as being an appropriate investment vehicle

for the global banking system to invest in. KPMG started this mess and KPMG must be exposed for their criminality and abject failure to act professionally as global economic oversight. There involvement has not been appropriately articulated by ZeroHedge to date. If ZeroHedge can't see the nexus of liability in this mess why should anyone else be able to see it? It is time for ZeroHedge to look inward and reflect on our shared failure to articulate the problems we are all facing en masse.

bwh1214's picture

But margin debt is at an all time high indicating a high degree of leverage in the market, this article seems to be saying don’t pay attention to margin debt because leverage is actually high due to other funding mechanisms.  Ok that’s fine but that is the same thing margin debt is saying.

TheRedScourge's picture

It looks as though Citadel and Millenium don't have any holdings which are over about 1.5% of their total portfolios. I suppose this means that when things start to unwind, pretty much the whole market is going down as these funds liquidate a little bit of everything.

Itchy and Scratchy's picture

Debt is never meaningless!

Jstanley011's picture

In fact, for all its confusion, the Fed doesn't realize that because it has onboarded countarparty risk exposure as one of its primary functions, there is no hope that a return to normalcy will ever be achieved.

That, right there, may just be the best in-a-nutshell overview ever penned of where Fed actions have brought us.

Metaphorically, instead of letting them drown, the Fed plucked the saboteurs out of the water and into the lifeboats, which they are now in the process of swamping.

Good job, Ben.

yarak's picture

For others looking to learn the basics, NYU primer:



The Econ Ideal's picture

The money market was not the culprit in 2006-8; this market was used as a scapegoat for the crisis felt by those much more heavily leveraged to risky Repo and credit markets. The Fed used a rumor of runs on the money markets as a reason to bail out the special interests that were much more heavily leveraged to risky instruments and "agreements." This is the big lie of the 2008 "crisis." Yes, it was a crisis, but for those who held exposure (high counterparty risk) to very risky instruments, most notably OTC and otherwise very illiquid, including multiply 'hypothecated' Repo. Every one of us is paying for this bailout, to this day - and we all continue to fund the cheap money access to special interests. 

JenkinsLane's picture

Is not Citadel a de facto GSE?