How The Financial System Is Sructured
Is The US Financial System a House Of Cards?
Casey does an excellent job in this explanation. This is the first video in a multi-part series. Our thanks to Casey for allowing this repost.
How The Financial System Is Structured
Check Out Our Crypto Privacy Site: CryptoGrizz.com
Check Out Our Crypto Trading Site: CryptoGrizzTrader
Structure of the Financial System (Inverted Card House?) – Beginners’ Guide
25,852 views
Jul 5, 2021
218K subscribers
VIDEO TRANSCRIPT
00:00
Is the cryptocurrency market a card house that could collapse at any moment?
00:04
And if so, what’s underneath the card house?
00:06
A strong foundation?
00:07
A rickety table?
00:08
Or worse, another card house…
00:10
Hello, I’m Crypto Casey and this is the first video in a three-part series where we
00:14
will investigate whether or not the cryptocurrency market, as well as the entire global financial
00:18
system, is indeed on the verge of collapse.
00:21
This is a beginners guide where we will break down step-by-step how the traditional financial
00:25
system is structured, how the cryptocurrency market is structured, what stablecoins are,
00:30
their role in the cryptocurrency market, and why stablecoins will both drive massive global
00:35
adoption of cryptocurrencies, while also potentially threatening mass global adoption of cryptocurrencies.
00:42
Our goal by the end of this video series is for us to understand the traditional financial
00:45
system’s relationship with the cryptocurrency market, and if a crypto collapse can happen,
00:50
how and when it could happen, and what we can do to protect ourselves as investors in
00:55
the space.
00:56
Awesome.
00:57
So let’s get started.
01:07
So most people that venture down the rabbit hole into the crazy crypto world are fascinated
01:12
by the idea of getting very rich, very quickly, with little-to-no effort.
01:17
After some time, then they become mesmerized by the charts, and want to learn how to read
01:22
the charts, and use the charts to predict the future, and use margins, options, and
01:27
leverage to make even more money very quickly with little-to-no effort.
01:31
And 99.9% of the time, they get rekt, absolutely rekt.
01:35
And either crypto becomes the bane of their existence and they vow to never touch it again,
01:39
or they get up and try again only to experience the same fate.
01:42
Unfortunately since the development of easy, gamified user interfaces in investment applications
01:47
like Robinhood coupled with the covid lockdowns over the past year,
01:51
a lot of people’s first exposure to and interaction with self-directed investing practices
01:56
happened recently and on a massive scale during a time when both the stock and crypto markets
02:02
pretty much only went up and up and up.
02:04
Everyone was a winner and everyone became an addict.
02:08
Only recently, have a lot of the new crypto investors experienced some seismic, gut-wrenching
02:12
pullbacks.
02:13
And what do they do?
02:15
Usually, they sell.
02:16
So I wanted to paint this picture of the average “investor” in crypto for you, to better
02:20
explain why they are in fact the complete opposite of an investor.
02:24
What I just described is a crypto tourist at best.
02:27
They bought in less than a year ago and sold in less than a year.
02:30
And THAT is not investing at all.
02:33
It’s not even a bastardized version of investing.
02:35
It is absolutely speculation, or glorified gambling.
02:38
So before we get started, it’s important for us to understand the difference between
02:42
speculation and investing in cryptocurrency.
02:45
What is Speculation in Crypto?
02:48
Speculation in crypto is when someone throws money into a project without doing extensive
02:51
research with the hopes and prayers of making a profit in a short period of time, which
02:55
is usually less than 12 months.
02:57
Now, what we need to be in crypto is not speculators, but rather investors.
03:02
So, let’s clarify what investing is.
03:05
What is Investing in Crypto?
03:07
Investing in crypto is when someone allocates money into a project after conducting extensive
03:11
research with the intention of making a profit in the long term, which is usually over a
03:17
year,
03:18
but since the technology and asset class is still so new and high-risk, serious investors
03:21
in crypto should realistically be planning to invest for a 2 to 5+ year timeframe, and
03:27
all the while remaining active in the space.
03:30
Investors in crypto are not only investing their money, they are investing their time
03:34
by learning about how finance & economics work, as well as keeping up with global news
03:38
affecting the crypto markets,
03:40
the ever-changing regulatory landscape around crypto, progress of the projects they’re
03:45
invested in, potential competitors of those projects, activity in the traditional stock
03:49
market, and a myriad of other things that influence the cryptocurrency industry at large.
03:54
It’s not easy, and as the saying goes, if it were easy, everyone would do it.
03:58
So with any self-directed investment activity, work is required to reap a reward.
04:03
And the more risk you take on, the more work required to potentially realize more gains,
04:08
because you could also lose your investments.
04:11
So another key characteristic of a serious investor in the crypto space is to never invest
04:16
more than you can afford to lose.
04:18
Nice.
04:19
Now that we have clarified the difference between a speculator and an investor, let’s
04:23
investigate whether or not crypto is a card house that could potentially: collapse in
04:27
the short or long term for a short or long period of time, collapse in the short or long
04:32
term forever, or not experience a collapse whatsoever, all from the viewpoint of an investor.
04:38
Chapter 1: The Structure of the Traditional Financial System
04:42
In this chapter we will break down 7 concepts to help us better understand the foundation
04:47
upon which all available investments reside, including crypto.
04:52
Concept 1: Fractional Reserve Banking
04:54
Fractional Reserve Banking is just a fancy term that describes the system where banks
04:58
are required to keep a certain amount, or fraction, of the amount of money people deposit
05:03
into their bank accounts.
05:04
For example, let’s say for every $100 you deposit into your account, per the fractional
05:09
reserve banking system, the bank only has to keep $10 of the total deposit and is allowed
05:15
to lend out the rest.
05:16
This fraction of deposits banks are required to maintain are known as reserves.
05:22
So the $10 dollar fraction of the $100 dollars you deposit into your bank account, is held
05:26
as reserves.
05:27
And the fraction of deposits banks are required to maintain are known as reserve requirements.
05:32
Hence the term, fractional reserve banking.
05:35
The fractional reserve banking system was created as a way to allow for the expansion
05:40
of the economy.
05:41
Here’s how:
05:42
For example, imagine a business deposits $100,000 into their bank account.
05:48
Assuming a 10% reserve requirement, the bank keeps $10,000 of the deposit to maintain the
05:54
reserve requirement, and then loans out the other $90,000 to a person.
05:59
This person then deposits the $90,000 loan into their bank account and their bank keeps
06:05
$9,000 of it to maintain the 10% reserve requirement, and then, what happens next?
06:10
Yes, that bank lends out the other $81,000 to another person or company etcetera.
06:16
So that single $100,000 deposit by the business at the beginning of this analogy effectively
06:21
created $271,000 in the financial system.
06:26
And this process can keep repeating over and over again, creating more money in the economy,
06:31
all courtesy of the fractional reserve banking system.
06:34
Interesting, right?
06:35
A little unsettling?
06:37
What happens if a large percentage of people or businesses want to withdraw their bank
06:41
deposits and not enough money is available to cover it?
06:44
Well, this happened once during the Great Depression and it caused the single largest
06:47
bank failure in American history.
06:50
Since then the Federal Deposit Insurance Corporation, or FDIC, was formed to insure deposits in
06:56
US banks in the event of bank failures.
06:58
Nice, what a relief right?
07:00
Our money in our banks is safe and secure in the event of another massive bank failure.
07:05
Kind of… there are three caveats to be mindful of when assessing whether your deposits are
07:10
insured: 1) your banking institution must be a member firm with the FDIC to qualify.
07:16
Following that, 2) the FDIC only insures deposits made into certain types of accounts which
07:22
generally include checking, savings, CD’s, money market accounts, IRA’s, revocable
07:27
and irrevocable trust accounts, and employee benefit plans.
07:31
The FDIC does not insure mutual funds, annuities, life insurance policies, stocks, or bonds.
07:38
So assuming your banking institution is a member firm of the FDIC, and your deposits
07:43
are in a type of account covered by the FDIC, the final caveat 3) is that only $250,000
07:50
per person or depositor is insured.
07:53
Meaning if you as an individual have, let’s say $300,000 deposited in a checking account
07:58
with an FDIC member bank, in the event of a bank failure, $50,000 of your money is not
08:04
insured and could be unrecoverable.
08:06
So here’s a quick tip if you have more than $250,000 you choose to keep in a banking account:
08:11
consider opening accounts with several different banking institutions that are FDIC members
08:16
to spread out the deposits to have more FDIC coverage.
08:20
Awesome.
08:21
Now that we know how the fractional reserve banking system works and the fail safes put
08:24
in place with the FDIC to mitigate some damage if the system collapsed, next let’s talk
08:29
about other ways all of this money we earn, spend, borrow, lend, withdraw, and deposit
08:35
with banks is created and how the government manages it.
08:39
Concept 2: US Treasury Bonds
08:41
The Federal Reserve is the central bank of the United States and in control of the creation
08:46
and management of money.
08:47
And the Federal Reserve controls the US money supply in two ways: one, by digitally adding
08:53
and subtracting money to and from major banks, and two: by issuing, buying, and selling US
08:59
treasury bonds.
09:00
So let’s break down what a US treasury bond is and its role in the management of money
09:05
in our economy.
09:06
First, what is a bond?
09:08
A “bond” is just a fancy word for a loan.
09:11
So bonds are loans, or debt instruments.
09:13
And “US Treasury” bonds refer to debt issued by the US Government.
09:17
So the Federal Reserve issues debt in the form of US Treasury bonds, and also engages
09:22
in buying and selling these US Treasury bonds to control the money supply.
09:26
Let’s talk about how this is done.
09:28
Imagine the current state of the economy, where there’s a certain amount of US dollars
09:32
circulating between banks, hedge funds, and other financial institutions.
09:36
When the Federal Reserve issues US Treasury Bonds, these entities can use some of their
09:40
dollars to buy the bonds.
09:42
And the dollars they give to the Federal Reserve in exchange for the bonds is then taken out
09:46
of circulation and locked up with the fed.
09:49
The Federal Reserve uses the money it receives to pay down debts or to fund improvements
09:53
to infrastructure or similar.
09:55
When financial entities buy US Treasury bonds, the amount of money in circulation decreases.
10:00
And when financial entities sell US Treasury bonds back to the Federal Reserve, the amount
10:05
of money in circulation increases.
10:07
So why would financial entities want to buy US Treasury bonds in the first place?
10:11
Well, treasury bonds are assets similar to blue chip stocks like Apple that pay their
10:16
stockholders dividends over time; except by holding treasury bonds, the holder receives
10:21
set interest payments over time.
10:23
And instead of these assets being backed by a single corporation like Apple, they are
10:27
backed by the US Federal Reserve, making them a safer, more pristine asset.
10:32
In fact, US Treasury Bonds are deemed the safest and most pristine asset by many, especially
10:36
right now which will be important to stay mindful of throughout this video series.
10:41
So when financial entities or people feel uncertain about markets and the economy at
10:45
large, they typically choose to buy and hold treasury bonds because they are less risky
10:49
than other assets.
10:50
Cool.
10:51
So we know why financial entities want to buy US treasury bonds, because: they are deemed
10:55
safe, pristine assets that pay guaranteed fixed interest over time, they’re backed
11:00
by the government, and thinking back to how the fractional reserve banking system works,
11:04
banks have both requirements and incentives to keep assets on their balance sheets so
11:08
they can create loans, which are income generators for them.
11:12
And this brings us to our next concept.
11:15
Concept 3: The US Treasury Bond Market
11:17
So it’s important to understand that when new US Treasury Bonds are issued by the Federal
11:22
Reserve, they go up for auction.
11:24
This is the primary place where new bonds originate.
11:28
Financial entities can bid on the bonds and if they acquire bonds, they can choose to
11:32
keep them or sell them in a secondary market known as the US Treasury Bond market.
11:37
The US treasury bond market is where financial entities like banks, hedge funds, and other
11:42
financial institutions can buy and sell US Treasury Bonds that were already previously
11:47
issued by the Federal Reserve.
11:49
Simple enough, right?
11:50
Cool.
11:51
Onward to:
11:52
Concept 4: The Repo Market
11:54
The work “Repo” stands for “repurchase agreements.”
11:56
And a repurchase agreement is just a fancy word for a short term collateralized loan.
12:01
The repo market is where financial entities can sell assets like US treasury bonds for
12:06
the short term in exchange for cash with a promise to buy back or repurchase the assets
12:11
at a higher price.
12:13
The buy back or repurchase term is usually overnight, but can be a week, two weeks, or
12:18
one month depending on the terms of the repurchase agreement.
12:21
So when banks, hedge funds, or financial institutions need cash to meet reserve requirements or
12:26
for liquidity, they can temporarily swap treasuries they have, for cash from banks in the repo
12:32
market.
12:33
And when the term of the loan expires, the entity buys back the treasury at a higher
12:37
price, similar to an interest payment.
12:39
The price to repurchase the treasury can be dictated in a few different ways.
12:43
One, by the amount of money in circulation.
12:46
The more money in circulation, the lower the interest rate, and vice versa; the less money
12:50
available, the higher the interest rate.
12:53
Two, the supply and demand of money.
12:55
If there’s more demand for cash than the circulating supply, interest rates can get
13:00
too high.
13:01
And when this happens, the Federal Reserve usually steps in and buys treasuries in exchange
13:05
for cash to put more cash into the ecosystem, which, in turn, lowers interest rates or the
13:11
cost of borrowing money.
13:12
And three, how risky the buying or borrowing entity is.
13:16
So if the entity entering into the repurchase agreement is not financially stable, or possibly
13:21
close to insolvency, the repurchase price of the treasuries will be much higher, because
13:26
they are a much riskier borrower.
13:28
Which brings us to the next concept –
13:30
Concept 5: Rehypothecation
13:32
When there are a lot of risky borrowers in the repo market, the price to repurchase treasuries
13:37
or essentially borrow money, increases.
13:40
And when there is high demand for treasuries in a market with a lot of high-risk borrowers
13:44
with no collateral, the available supply of treasuries decreases.
13:49
Banks will flat-out refuse to lend money to high-risk borrowers that don’t have any
13:52
treasuries or other good collateral to secure a loan.
13:55
So when the amount of available treasuries is low, and the demand for cash is high among
14:00
a lot of high-risk borrowers on the brink of insolvency, entities will engage in what’s
14:06
called rehypothecation.
14:08
Rehypothecation is just a fancy word that basically describes an entity letting another
14:12
entity use their treasuries to secure a loan.
14:15
For example, let’s say a hedge fund needs cash, but doesn’t have any treasuries to
14:19
secure a loan themselves.
14:21
The hedge fund can call in a favor from one of their financial institution buddies that
14:25
has treasuries and essentially borrow it from them to use as collateral for the loan.
14:31
When financial institutions let other entities borrow their treasuries, the treasuries are
14:35
deemed rehypothecated.
14:37
And as you can imagine, rehypothecated treasuries aren’t exactly a safe form of collateral
14:41
because, at the end of the day, the banks lending the money don’t know who actually
14:46
owns the treasury.
14:47
And they also don’t know how many times that treasury has been rehypothecated, because
14:51
yes, the same treasury can be hypothecated multiple times allowing multiple entities
14:57
to essentially re-use that same exact treasury as collateral.
15:02
Meaning a single treasury can be on multiple entities’ balance sheets simultaneously.
15:07
This would be like you and 20 other people sharing the same bank account, and let’s
15:11
just say the bank account has $100 in it.
15:13
And you and 20 other people are telling lenders you are trying to borrow money from that you
15:18
definitely have $100 in your account in case things go awry.
15:21
Yeah, not ideal.
15:23
So imagine the difference between a treasury and rehypothecated treasury, as a treasury
15:28
being hard cash or a debit card transaction, versus a rehypothecated treasury being a credit
15:33
card transaction.
15:34
Would you rather someone pay you with cash or with a credit card?
15:37
Exactly.
15:38
So since covid, the Federal Reserve has been adding record amounts of cash into the economy,
15:43
by merely printing it out of thin air and through buying US treasury bonds, which is
15:47
further decreasing the available supply of pristine collateral.
15:52
Which brings us to the next section.
15:54
Concept 6: The Reverse Repo Market
15:56
A huge supply of cash and low supply of pristine collateral like US treasuries has caused the
16:01
“reverse repo market” to explode recently.
16:04
A reverse repo is just the other side of a repo.
16:07
For an entity selling a US treasury to someone for the short term, the transaction is a regular
16:12
repo or repurchase agreement.
16:15
For the entity buying a US treasury for the short term, the transaction is a reverse repo,
16:20
or reverse repurchase agreement.
16:22
Why is the reverse repo market exploding right now?
16:25
Well, as we described earlier, it’s because there has been both an increase in demand
16:29
for collateral versus cash, and a supply shortage of preferred collateral, US treasury bonds,
16:35
in the repo market.
16:37
Since the fed has been both printing news dollars into the ecosystem and buying up all
16:41
the treasury bonds from the repo market in exchange for cash, further increasing the
16:45
amount of dollars in the ecosystem: banks and financial institutions are bursting at
16:50
the seams with excess cash.
16:52
As a result, all these entities with excess cash are now saying to other entities, hey,
16:56
we will pay you interest to borrow our cash, in exchange for treasury bonds.
17:01
So instead of the borrower having to pay the lender interest on the cash loan, the lender
17:05
is literally paying the borrower to take their money.
17:08
This is because the cash lender wants to pay the cash borrower interest to borrow their
17:13
collateral.
17:14
Strange right?
17:15
So all the financial institutions would rather pay to borrow US treasury bonds than hold
17:20
cash.
17:21
They want the collateral, not the cash.
17:23
Now, why is it so?
17:24
Well, they could be making a profit from taking the treasuries to the secondary bond market,
17:28
but also with so much cash in the ecosystem there is nowhere else for it to go.
17:32
But Casey, what about other less-risky assets like physical properties, mortgage-backed
17:36
securities, or corporate bonds.
17:38
Well, financial institutions aren’t daft and see the writing on the wall.
17:42
First of all, look at the housing market.
17:44
Financial institutions have been buying up physical property like crazy, sending prices
17:48
for homes to record highs.
17:50
So yeah, they’re buying property.
17:52
Next, mortgage-backed securities?
17:53
Which are bundles of home loans… in the midst of the longest rent, mortgage, and eviction
17:58
moratoria the US has ever seen?
18:00
Financial institutions know what’s going to happen when it supposedly ends at the end
18:03
of this month, July 2021.
18:06
Lots and lots of defaults on mortgages.
18:08
Nobodies going to be able to pay several months of mortgage payments all at once, and even
18:12
if repayment deals are worked out, there’s still a lot of risk to be mindful of.
18:17
So mortgage backed securities are far from being pristine collateral right now.
18:20
From there, corporate bonds and stocks: yeah, we all know they’ve been artificially propped
18:25
up from covid stimulus packages.
18:27
Big zombie corporations that should’ve failed years ago still have a pulse, for now.
18:32
In addition, the overall traditional stock market is well overdue for a correction.
18:36
So yeah, US treasury bonds are where it’s at.
18:38
In a pick your poison economy, US treasury bonds are the least poisonous right now.
18:43
But if entities are scrambling to buy up all of the treasuries from the treasury market,
18:47
what happens to the repo market?
18:48
Well, it basically has what caused this whole issue in the first place: a shortage of sufficient
18:54
collateral.
18:56
Then what happens is more of the same we discussed earlier: more rehypothecation, where entities
19:00
start borrowing each others’ collateral in order to stay liquid.
19:04
And if 5 or 10 or 20 entities are using the same exact treasuries as collateral to stay
19:09
liquid, what happens if one of them goes insolvent?
19:12
Yeah, it’s basically a game of musical chairs with, like, 1 chair per 20 people trying to
19:16
sit in it when the music stops.
19:18
And that’s just assuming banks with cash would be willing to lend to all of the entities
19:23
using treasuries that have been lent out to god knows how many others.
19:27
And what if it’s not just the second bond market where rehyophecated treasury bonds
19:30
are being circulated?
19:32
What if the Federal Reserve itself is also redistributing rehypothecated treasury bonds?
19:37
Check out this interesting idea I came across from one of my favorite sources, George Gammon’s
19:41
YouTube channel.
19:42
Here’s an excerpt directly from the New York Federal Reserve’s website about Reverse
19:46
Repurchase Agreement Operations:
19:48
1 – When the Desk conducts RRP, or reverse repurchase agreement, open market operations,
19:54
it sells securities held in the System Open Market Account (SOMA) to eligible RRP counterparties,
20:01
with an agreement to buy the assets back on the RRP’s specified maturity date.
20:06
And here’s the key sentence to soak in: This leaves the SOMA portfolio the same size,
20:11
as securities sold temporarily under repurchase agreements continue to be shown as assets
20:16
held by the SOMA in accordance with generally accepted accounting principles,
20:21
but the transaction shifts some of the liabilities on the Federal Reserve’s balance sheet from
20:25
deposits held by depository institutions (also known as bank reserves) to reverse repos while
20:31
the trade is outstanding.
20:33
These RRP operations may be for overnight maturity or for a specified term.
20:38
Wait, so did the Fed just admit to allowing a single treasury that they have on their
20:43
balance sheet to remain on their balance sheet while they sell it to another entity?
20:47
Or even multiple entities?
20:49
Have they started implementing a fractional reserve system with US treasury bonds to keep
20:53
the music playing?
20:54
Probably, because the Fed knows that if there isn’t enough pristine collateral or US treasury
20:59
bonds to keep the reverse repo market going, the whole global financial system comes crashing
21:03
down pretty much.
21:04
I mean look at this:
21:05
2 – This is a graph showing the total amount of money in billions being transacted in overnight
21:11
reverse repurchase agreements since 2016.
21:14
Just this past Wednesday on June 30th, it hit over $990 Billion dollars worth of overnight
21:19
reverse repos.
21:21
Meanwhile 3 – On June 24th, the Federal reserve released their latest balance sheet showing
21:25
$326 Billion dollars worth of US treasury bonds.
21:29
And if we refer back to the excerpt from their website, this number on their balance sheet
21:34
remains unchanged regardless of whether or not they sold treasuries in the reverse repo
21:39
market.
21:40
Also keeping in mind that these are just reverse repos done with the Fed.
21:43
The entire reverse repo market where financial entities like banks and hedge funds can transact
21:48
between each other is over $4 trillion dollars.
21:51
So is the whole traditional financial system propped up on unlimited, baseless cash and
21:56
just a few treasuries that have been rehypothecated into oblivion?
21:59
It’s possible, which brings us to our final concept in this chapter:
22:04
Concept 7: The US Financial System Card House
22:07
At the time of this video, the crypto markets are still highly correlated with the traditional
22:11
markets and on an abstract, conceptual level, still utilizing the traditional global financial
22:17
system as a foundation.
22:19
So let’s take a look at the current state of the US financial system in this analogical
22:23
visual representation of 3 – an inverted or upside down card house.
22:28
The bottom and lowest rows represent assets with less perceived risk, and as we move higher
22:33
up the inverted card house, these assets have more perceived risk.
22:37
So at the bottom here, we have a few real deal US Treasury Bonds being propped up by
22:41
Fed Chair Jerome Powell and Treasury Secretary Janet Yellen.
22:45
Above that, we have a slew of rehypothecated US treasury bonds,
22:49
all of which we have no idea who actually owns the actual treasury, and no idea how
22:54
many different balance sheets the treasury exists on simultaneously.
22:57
Here we also have physical property like houses, apartments, buildings, and other types of
23:03
real estate.
23:04
On top of that we have mortgage backed securities representing all of the liens against the
23:07
real physical property, as well as some commodities like gold, oil, corn, cattle, etcetera.
23:13
Above that, we’ve got corporate bonds, blue chip stocks and equities like Apple, Google,
23:18
Amazon, and similar.
23:19
As well as stocks, equities, and corporate paper of smaller, more risky corporate entities.
23:24
And finally, representing the largest quantity of assets harboring the highest risk are options,
23:29
futures, and derivatives, which in the traditional markets is just legalized gambling, where
23:34
people pretty much make bets on what the prices of all the other assets in this chart will
23:39
be in the future.
23:40
So yes, calling spades, spades here: behold the structure of the current traditional financial
23:45
system, that also currently serves as the foundation of the entire cryptocurrency market.
23:51
Fun fun.
23:52
Awesome.
23:53
Congratulations for making it through chapter one in this video series.
23:56
Yes, it was long, tedious, and boring, but now we will better understand and appreciate
24:01
how this relates to the crypto market and what we can do to protect our investments.
24:07
This is the first video in a three-part video series, so make sure to check them all out
24:11
to get the full scoop.
24:12
If you enjoyed the video make sure to like this video and subscribe to my channel for
24:15
more crypto content.
24:17
So what do you guys think about the current structure of the traditional financial system?
24:20
Was the video explanation clear or do you have other questions?
24:23
How about that inverted card house analogy?
24:25
Clever or concerning?
24:27
Let me know in the comments below.
24:29
Be safe out there.