The End of Western Rehypothecation- Pozsar Style

Put a fork in rehypothecation as a tool of financial leverage to generate outsized returns by G7 nations using BRICS resources. It’s done.

1. WHAT: is Zoltan’s Gold-mageddon
2. WHY: is it the death of rehypothecation
3. HOW: Will futures markets react
4. WHAT-IF: It can be stopped

Intro

Authored by Goldfix

Below is the playbook for the most likely way the end of Western rehypothecation happens. The writing may get a little wonky as we alternate between academic & trading mindsets, and the mechanisms can be debated, but this is largely how it will happen. When it is done, whoever is holding the bag; be it bank, nation, economic model, or citizenry, will almost certainly collapse economically. Perhaps slowly like frogs in pots, or perhaps all at once. 

Anyway..here we go

Here is Pozsar’s hypothetical situation restated. He muses out-loud what would happen if Russia first accepted Oil’s peg at $60. Russia, in his scenario, reciprocates by pegging 1bb oil at 1/2 gram of gold which currently is equivalent to $30. The economics of the Oil/Gold/Dollar triad would look like this (where g=grams; bb=barrels)

1. IF: 1bb= $60 pegged ( If x=y)
2. AND: 1bb = 1/2g pegged (And x=z)
3. WHERE: gold/dollars are not pegged to each other.
4. THEN: 1/2g = $60 given free exchange-ability. (Then y=z)

Why?

This whole thing starts out as: Nations need energy for economic growth. Oil is, on balance, currently the most desirable energy source globally. These nations, in turn, then seek to exchange something for oil their counterparty will accept as a Standard of Trade. A Standard of Trade is something universally accepted for transactions with other parties.

Russia, in Pozsar’s example would be telling the world it will take Gold as payment for Oil, because (and this is key) some other nation will accept that same Gold as payment from Russia to buy stuff too. Gold thus becomes a standardized settlement medium for three economically interdependent nations.

Russia would make the USD and Gold compete as mediums of exchange. You can now buy Oil for either $60 or 0.50gram gold. The MOE you use to buy oil is the one you simultaneously have the most of and the least alternate use for in other economic trade

The End of Rehypothecation…

There are many ways to envision how this plays out in a free market. The arbitrage trade, the substitution effect, Gresham’s law etc. For this note, as long as buyers have a choice to pay for oil with either $60 or 0.50g gold; be assured that either the price of Gold goes up in dollars or the price of dollars goes down in Gold.

If however, some external force (restraint of trade, sanctions,war etc) prevents the new Y=Z equilibrium from establishing, then ownership of the three resources (Oil, USD, and Gold) as well as any other asset that uses energy as a cost input will rebalance instead. Price fixing (via not permitting Gold swaps for USD) eventually creates scarcity.

Ultimately it all hearkens back to a February post of his about the coming shortage of collateral. Which he was right about.

Back then he said , “A crisis is unfolding. A crisis of commodities. Commodities are collateral, and collateral is money…” –source. He hadn’t spoken of Gold since that February post. But in this current note, he is sounding the collateral alarm again but for Gold.

The 2 for 1 Gold/oil swap is hyperbole even if Zoltan says it isn’t. A move like that all at once would be economic suicide for Russia and likely start WW3. But it is instructive to know the worst case scenario when contemplating a more likely scenario. Zoltan’s scenario is completely reasonable at different price points.

What’s more, it is actually happening. Ghana has a buyer of Gold for Fuel. That buyer in turn must have someone who will exchange Gold for another good they want. Ghana meanwhile doesn’t have to sell CEDI for USD anymore. Gold up, CEDI up, USD down.

We think you will agree, dialing down Zoltan’s Gold-mageddon scenario is not much better for rehypothecated western bank shorts, even at current market prices if things like what just happened with Ghana continue.

Next we move from supply/demand economics to briefly recap the rationale for the rehypothecation of Gold and other assets.

If Russia or another country were to finalize its energy dealings with Gold as settlement medium even at current prices… well… that’s a whole lot of dollars people won’t be needing to use, and a whole lot more Gold needed to be on hand. This would happen even if Russia priced oil to be bought using 1 full gram of gold per barrel.

Rehypothecation Analogy
Which person gets screwed? pic.twitter.com/8wkSRjC5qm

— VBL’s Ghost (@Sorenthek) December 29, 2022

In other words, there would likely be a crisis of good Gold collateral for open futures contracts. Rehypothecation is all about multiple claims on limited collateral. And as we saw in February, Pozsar is all about collateral.

Which brings us back to his recent statement:

[B]anks have been managing their paper gold books with one assumption, which is that [Nation] states would ensure gold wouldn’t come back as a settlement medium.

Remember, he is telling us banks use gold rehypothecation as a profit center predicated on the assumption by governments, gold would never come back as a medium of exchange for settlement between countries. The monetary market-structure needed to support fiat made sure of it.

But Gold is coming back as an MOE. That probably makes banks with paper gold risk a little nervous.

Because of the tacit government bargain between nation-states and banks; Bullion dealers were comfortable rehypothecating gold (and silver) due to permanent fiat hegemony. They believed Gold would not be used as a final settlement medium in business ever again. Thus, it would not ever be needed for physical delivery enmasse. Gold had become the proverbial sardines: traded but never eaten. Yet here we are with Hungarian economists describing the end of banking if gold competes with the USD as settlement medium.

If a crisis like the one Pozsar describes were to occur a death knell would sound for any bank with rehypothecated Gold shorts. Multiple claims on Bullion would come in as available collateral shrank. The price of Gold would skyrocket due to physical demand earmarked to close oil deals with Brics producers.

Paper gold contracts would not cut it in a trust-less world. Deferred delivery of gold would be extremely expensive accelerating the dollar’s demise. Ask the Silver producers who got squeezed by Warren Buffet.

The banks could conceivably be destroyed, if that worst-case were to happen in Gold.  Somebody wants to actually use their sardines now. What happens when futures sardines are inedible but spot sardines are fine?

If this all doesn’t quite hit home yet, think of it this way. Why did LME Nickel blow up its clients? A lack of good collateral and too many open shorts was the reason for us. In essence a short squeeze pure and simple. but a huge one. Rehypothecated shorts got killed. This is what would happen to gold, but much, much worse if permitted to.

A couple commodity firms wouldn’t be panic-buying nickel to cover for a short client if that happened. The world would be demanding its physical gold back. The exchanges would be treated like banks being run on. Shutting them would implode the economy. Leaving them open and making delivery could bankrupt the country. The giant sucking sound would be what Gold remained in the West going East. What would that look like in the futures markets?

Now lets take a look at how the futures markets would digest all this if it happened.

The western Gold futures curve would go backwardated. That is unheard of for any length of time in Gold. Money should never backwardate. But that is what happens when governments throttle it and demote it to collectible status. The shit then will truly hit the fan. Bankers understand this.

This is what Mercantilistic behavior as reaction to collapsing global markets causes. A collateral crisis that morphs into natural resource war…

Backwardation in money is economic death for any country continuing to use that asset as money by depletion of that asset, or economic deflation because noone will loan money out for term.

True modern (financializable) money cannot backwardate, ever. The future value of money is money plus money. That job is handled by interest rates. But Gold would backwardate simply because you cannot pay off someone with dollars to defer their delivery of gold. Nobody wants the dollars. They want the gold. This is where the fallacy of the gold/dollar correlation lies. As long as people want Gold priced in dollars, then gold is not money. To the extent something does backwardate, that means it is not fully monetized. If gold bacwardated during this crisis (it would) while still being unmonetized in the west (it wouldn’t be) that would be the death of the global economy, and possibly entail World War 3.

Killing rehypothecation by holding commodities in reserve for use or BRICsCOIN backing use creates scarcity in the West. Some would say artificial.
We would say the financial leverage from decades of fiat and rehypothecation would be unwinding. There would still be plenty of natural resources, but the East would not be letting us leverage them anymore.
The modern standard of living  will get crushed. They will suffer immensely as well. But they know this already.

Finally, what can the west do to ameliorate the effects of the above if it happened.

One solution to Gold backwardation if it persisted would be the immediate 100% remonetizaton of all Gold globally. Confiscation would ensue in varying forms. The Comex and the LBMA would shut down. Force majeure would be declared. If that happened, a global depression could conceivably set-in almost overnight. Mercantilism would go parabolic and whole countries would close as they re-balanced their books.

Will it happen? It is already been happening at a glacial pace since the GFC. One thing that makes it not happen would entail complete separation of East and West trade and involve scarcity on both sides of the wall and a black market that slowly sucked the lifeblood out of the worst run economies.

KILLING OIL

The other way can be an alternative energy source that obviates Oil. Replacing oil means collapse of natural resource rich countries and their hopes for egalitarian currencies. Whoever controls that new energy decides what the money is. If the west cant save the petrodollar from the petroyuan, then it will try to kill oil to save the dollar. That is what renewable energy  is all about at core. Western Financial hegemony ( inside money) over Eastern Marxist Materialistic upstart (outside money)

There are other far more dangerous remedies we imagine. One is an economic race to the bottom hoping Russia/China have a civil war before we do. China does not want a destabilized Nuclear power on its border. 

We think if you connect the dots of what has happened these last few years between: the implementation of Basel 3, JPM’s Gold risk being broken out, EU Bankers saying they’d reprice Gold if they had to, and Oil for Gold trades going down between Russia, China, and others; you will see a pattern of slow remonetization of Gold as money. May be it was too slow, and that is what has the Brics up in arms now.

This is why, when all is said and done, even if Russia gets blown out of the water, money will never be the same again. The East has made it clear their money is not valued objectively, and until it is, they want their natural resource contributions of the economic pie to have more weight.

The West, in turn, even if it wins this Russian war, will do so while incurring much economic pain. They will compromise to make sure it doesn’t happen again.

Which is why, even in the best case scenario, money will never be the same again.

Bretton Woods 2 crumbled when the G7 countries seized Russia’s foreign exchange reserves. Keeping money inside financial institutions like the IMF was considered risk free. That is clearly no longer the case. Bretton Woods 3 will have to fix that.

“We are witnessing the birth of Bretton Woods III – a new world (monetary) order centered around commodity-based currencies in the East that will likely weaken the Eurodollar system and also contribute to inflationary forces in the West.” – March 2022

We completely believe after this war is over, money will never be the same regardless of who wins. Compromises will be made on both sides. Gold and Silver being remonetized might just be the booby prize for hell on earth

One final note: This kills democracy too. As fallout from division and acrimony and identitarian politics, the West won’t be able to get its own people to toe a patriotic line (Hi Klaus.) to stand against tyranny. They will increasingly use stimmies and sticks for compliance.  And so tyranny will grow on our side of the wall to get compliance. Therefore as Capitalism with Asiatic principles grows, Capitalism with democratic principles dies.

About the Author: VBL is a 30 year professional trader and expert in derivatives arbitrage and market structure. He is currently Professor of MBA Finance and editor of GoldFix.