A couple of years ago, it occurred to me that the 21st century financial system had come to resemble a huge ball of candy floss (or cotton candy, as Americans might say). For bankers had become so adept at slicing and dicing debt instruments, and then re-using these in numerous deals, they had in effect spun a great web of leverage and trading activity – in much the same way that sugar is spun in a bowl to create candy floss.
From a distance, that activity looked impressive. But the underlying asset base was surprisingly small. Thus the key question that has hung over the system – and is doubly relevant now – is whether that cloud of trading activity could crumble back into itself? And what might the impact of that be?
Now, a fascinating little paper has just emerged from the International Monetary Fund which sheds light on this. This article*, by Manmohan Singh and James Aitken, is not pitched at a mainstream audience; it focuses on the issue of “rehypothecation” and its link to shadow banking. But that is a pity.