Last week's Swiss National Bank shock, which reversed a key monetary policy, was a perfect reminder of how a single decision can hammer the global indexes like a tsunami.
On Thursday the Swiss National Bank (SNB) removed its "cap," under which 1 euro could buy no less than 1.2 Swiss francs.
In one day the franc soared more than 30% against the euro and the U.S. dollar. That instantly made Swiss exports 30% more expensive. The Swiss stock market fell 9% on Thursday and another 5.2% on Friday.
But forex traders got the worst of it.
Trusting that the long-standing Swiss National bank policy would not change, currency traders bet against the Swiss franc. They assumed a declining euro would not cause the trade to fall below 1.2, thanks to the cap.
But because traders with a Forex brokerage account can take their leverage to incredible levels, a major shift in currency valuations can lead to dramatic gains - or extremely painful losses.
And that's exactly what led to the crash of broker FXCM Inc. (NYSE: FXCM) on Friday. Several other small foreign exchange trading firms also were slammed.
Yet all the turmoil could have been prevented if the world had learned the lessons of the 2008 financial crisis.
Let's dig into the details of last week to find out what the Swiss National Bank shock can tell us.
One Thing the Swiss National Bank Shock Made Clear
When the Swiss central bank ended its cap, it made big losers out of anyone shorting the Swiss franc.
The world's largest foreign-exchange broker, FXCM, saw its shares fall 85% in pre-market trading. Ultimately, the New York Stock Exchange halted the stock as the company attempted to sort through the rubble and explain what had happened.
The official report indicates that the brokerage's clients owed the exchange $225 million because of the losses, but there wasn't enough capital to obtain. As a result, the firm immediately had a massive negative equity balance. Now it doesn't have enough cash on hand to meet its regulatory capital requirements.
Reports are also emerging that Citigroup Inc. (NYSE: C) lost roughly $150 million and fired its head of European FX trading operations after the Swiss National Bank ended its cap on the Swiss franc.
Bloomberg reports that Deutsche Bank AG (NYSE: DB) had initial losses of $150 million, while Barclays Plc. (NYSE ADR: BCS) lost $100 million.
But why did the Swiss National Bank shock have such a shattering impact, and more importantly, what can we learn from it?
The short answer: A G-5 central bank broke a promise to the markets and reversed course without warning or worry.
Centralized planners can turn on a dime and affect just about everyone and everything with the stroke of a pen or the push of a button.
And that action tells us something. Swaha Pattanaik of The New York Times said it best on Thursday: "The first lesson is never trust a central banker when he or she makes a commitment or gives guidance."
Many investors were betting on policy to make them a profit, and now they're out hundreds of millions.
The whole thing sounds familiar, doesn't it? It's one more reason to remain cautious as the U.S. central bank, the Federal Reserve, continues to be the guiding light in our ongoing "economic recovery."
Why Was No One Ready for the Swiss Central Bank Shock?
FXCM is the world's third-largest currency brokerage. But it would no longer exist if not for an emergency $300 million loan from Leucadia National Corp. (NYSE: LUK).
A more honest label, though, would be "bailout."
The company got shellacked because it faced a $250 million shortfall after overleveraged investors could not settle accounts.
Wait a second...
An institution tied to the financial sector almost collapses because of too much leverage?
Sound familiar? It should. It happened in 1997, 2001, 2007, and 2008.
Go back far enough - to the Great Depression - and you'll get a really deep sense of déjà vu.
But it gets worse...
Turns out that in 2010, the Commodity Futures Trading Commission (CFTC) wanted to enforce a provision that would have made investors pony up $0.10 for every $1 in positions, representing a 10 to 1 leverage ratio on currency brokerage accounts.
But guess who helped lead the charge against the agency's plan?
None other than FXCM, which argued at the time that the CFTC's plan "would end currency trading as we know it."
In the end, only $0.02 per $1 needed to be pledged, or a leverage ratio of 50 to 1.
Needless to say, the rule would have dramatically altered the broker's fate on Friday.
Regulation for regulation's sake helps no one. But last week's Swiss National Bank shock tells us nothing is safe anymore. Not even positions supposedly protected by a central banker's word.
Increasing leverage standards remain the great financial temptation of our time.
But each and every time we give someone just a little more room... just a little more room... just a little more room - all in the name of "free markets" and "capitalism" - we end up poisoning those names and giving ammunition to those who seek the destruction of both.
The "leverage issue" is no longer a left or right conversation.
It's an up or down one.
Either our economy will strengthen with intelligent public policy, or we'll watch this system sink again.
The second lesson that we learned from the Swiss National Bank shock?
It's that when it comes to extreme financial leverage, we keep making the same mistake over and over.
What's Next for the Ailing Euro: Right on the heels of the Swiss National Bank shock comes a policy meeting of the European Central Bank. With the euro reeling, the big question is whether ECB President Mario Draghi will launch some kind of U.S. Federal Reserve-style quantitative easing (QE). And if he does, there's a way for investors to profit...
About the Author
Garrett Baldwin is a globally recognized research economist, financial writer, consultant, and political risk analyst with decades of trading experience and degrees in economics, cybersecurity, and business from Johns Hopkins, Purdue, Indiana University, and Northwestern.