What Actually Happened Today?

It seems early in the overnight carnage seen this morning pre-market that caused a fairly substantial gap down in the equity markets, the main stream financial press was initially blaming all of this on the crashing price of oil which was ironic given that oil was up at the time.

Like I often say, the Financial media make their living selling ads and the demand from retail or mom and pop investors is a need to understand why a complex system such as the stock market acted the way it did, even though the event has already passed, is discounted and largely irrelevant, call it the fear of the unknown or misunderstood, so millions of people tune in to media like CNBC for a 30 second sound bit of why the market acted the way it did, it's just people's desire to feel like they have some control in a system that is vastly beyond their understanding and even further removed from their control. Thus the 30-second sound bites as to why the market acted the way it did and the early financial media's attempt to blame "Falling oil prices", despite the fact they were up this morning!

What happened actually happened overnight in China causing the biggest 1-day drop in the Shanghai Composite since August of 2009, a -5.4% decline which many may rationalize as an overdue pullback due to the extraordinary gains in the same market over recent months, up nearly +50% since July despite falling real estate prices and clear indications of a economic slowdown. However, this had NOTHING to do with what actually happened.

To understand what happened, you have to understand a little about the term you've probably heard many times, but never quite understood, "THE SHADOW BANKING SYSTEM". While the Chinese actions were specific to a particular part of shadow banking, I'll "TRY" to provide a reasonable definition without turning this in to a term paper with cliff notes.

Most people associate credit, borrowing and other activities with traditional depository lending/banking institutions that are heavily regulated, that have access to Central Bank funds, have safety nets such as Federal Deposit Insurance and debt guarantees. However, a large portion of numerous financial transactions are carried out by the Shadow Banking System which in it's most elementary form would be considered financial intermediaries that do not accept deposits like traditional banks and as such are not regulated or are far less regulated.

These Shadow Banks are financial intermediaries that facilitate credit creation across the global financial system, but generally are not subject to regulatory oversight, however the Shadow Banking system can include regulated banks performing unregulated activities. Shadow Banking institutions are largely considered unregulated because they do not accept deposits like a traditional bank and as such are not subject to the same regulations. 

Some of the more "traditional" definitions of Shadow Banking institutions include: Hedge Funds, Credit Hedge Funds, Private Equity Funds, Money Market Funds, Credit Investment Funds, Structured Investment Vehicles, Securities Broker Dealers, Credit Insurance Providers, Securitization Finance companies and Mortgage companies.

Some of the services provided may be as basic as serving as a financial intermediary, for instance say an Institutional Investor like a Pension Fund that is willing to lend money and a Corporation that is looking to borrow money; these institutions serve as the intermediary either making a direct fee or the difference between the interest rates from the lender to the borrower.

Some of the other areas they are involved in include: Securitization vehicles, Asset Backed Commercial paper, Money Market Mutual Funds, create markets for repo-Repurchase Agreements, Unlisted Derivatives and other Unlisted Instruments, Credit Default Swaps, matching borrowers and lenders and providing longer term mortgages, student loans, car loans and extend credit to individuals or organizations that would otherwise not be credit worthy.

Because they do not accept deposits to avoid being regulated, they often rely on short term funding by asset backed commercial paper and/or repo agreements

It's generally accepted that these Shadow Banks do not have banking licenses, they do not accept deposits and as such are not subject to the same or any financial regulations unlike traditional depository institutions. This often allows them to extend more competitive rates, they often take far greater credit and liquidity risks and operate at higher levels of leverage without the capital requirements that are normally commensurate with these risks for regulated institutions.

However, there are so many global activities across broad spectrums that many transactions are intertwined with traditional depository/regulated institutions in transactions that are OBS (Off Balance Sheet) for the regulated institution and their activities that are OBS (Off Balance Sheet) are not visible to regulators or common investors. It is said that Shadow Banking institutions rival that of regulated, traditional depository banks, however the Bank for International Settlements (BIS- otherwise known as the Central Banks' bank) have said, 'Regulated banks are the largest Shadow Banks" via Off Balance Sheet transactions.

It is widely accepted that shadow banking was a primary cause of the 2007-20012 financial crisis as Shadow Banking Institutions served a large role in Sub-Prime. Even traditional depository banks were involved in large sub-prime lending via Off Balance Sheet Transactions. 

Hopefully it is clear by now that although there are true Shadow Banking operations and a lot of them, it's difficult to separate traditional regulated banks from the Shadow Banking industry either because of their relationships and intermingling in unregulated activities or their own direct Off Balance Sheet Shadow Banking activities. It hopefully is also clear what kinds of systemic risks Shadow Banking creates and the systemic dangers via the involvement of traditional banks through contagion.

The F_E_D has warned numerous times that the next Financial Crisis will be a direct result of the Shadow Banking Industry. In fact it is fairly well known that the credit and liquidity freeze of the 2008 financial crisis was largely a freeze among shadow banking entities in the wake of Lehman.

Last night's actions out of China seem to be an effort to reign in credit as part of broader reforms and perhaps pop the equity bubble by aggressively going after sources of funding for stock and bond market speculation. 

China's securities clearing house for their two equity markets issued new regulations curbing the type of assets that they'd accept for repo (repurchase) agreements that typically last between a period of overnight to 182 days and have been used largely to finance stock buys. Specifically targeted were corporate/government bonds which have spiraled out of control in recent years, with a rating of AAA or lower or sold by issuers graded as lower than AA , making this type of collateral ineligible for repo agreements/short term financing. After the massive decline (ultimately -5.4%, the PBOC tried to stabilize the market by intervening in FX markets, setting a stronger CNY fix which is PBoC tightening. However, USD/CNY actually saw its largest intra-day rise since 2008.

According to some estimates, the new collateral rules would disqualify approximately $125 trillion Yuan of outstanding corporate issues listed on China's two exchanges, approximately 60% of all outstanding , listed Corporate Bonds on China's 2 exchanges (approx. $202 bn $USD).

By comparison, the US's two largest custodian banks of repoable assets, State Street and Bank of New York, hold a combined total of approximately $55 trillion in assets or approximately three times the market cap of the S&P-500 (repoable securities). Imagine what any move by these two banks might do to the markets if the restriction of a mere $202 billion of Chinese repo assets sent the Shanghai Composite down 5.4% in a single day, the largest decline in a single day since August of 2009.