(Bloomberg Opinion) -- The Federal Reserve ushered out a second wave of quantitative easing Monday. But the worst scramble for cash is happening in an opaque corner of the market, where Chairman Jerome Powell has little control. What we’re witnessing is a system-wide margin call.
With the coronavirus outbreak intensifying, asset managers are getting squeezed by a record outflow from bond funds and billions more from stock funds. Even bigger withdrawals are probably happening in the over-the-counter world, where trades are conducted out of public eye, through broker-dealers. When traders get margin calls, they resort to selling their most liquid assets, usually stocks and U.S. Treasuries. This only deepens the slide.
Consider OTC derivatives, which are mostly betting slips on the future movements of interest rates and currencies. When regulators tightened capital rules in the wake of the global financial crisis, transactions in these securities became cash cows for banks to boost their profits with minimal impact on their balance sheets. Currency swaps, as I noted last week, are now an important channel for foreign lenders to get a hold of U.S. dollars from their American peers.
As of June 2019, the notional amount of such derivatives rose to $640 trillion, the highest since 2014, data provided by Bank of International Settlements show. Gross market value, which gauges how much money would be transferred if all trades shut down, totaled about $12 trillion in mid-2019, 30% lower than in 2014.
In ordinary times, gross market value is a better gauge of the amount at risk because of netting agreements. If a bank is $99 short on a trade and $99.10 long with other clients, its exposure is only 10 cents.
But we live in extraordinary times, and gross market value can also serve as a proxy for how much money the financial system has put aside to sustain that $640 trillion OTC derivatives exposure, according to research conducted at Prerequisite Capital. As of last June, the margin requirement, which the firm defines as the ratio between gross market value and notional amount, was 1.9% — a record low. In other words, there isn’t enough balance sheet provision for black swan events.
After the collapse of Lehman Brothers Holdings Inc., the margin requirement for those OTC derivatives jumped as well, to 5.8% from 2.2% in early 2007. The derivatives market, in turn, became a $24 trillion scramble for cash and collateral.
Similar worrying signs are emerging again. Just like 2008, market volatility is spiking and dollar funding is tightening. To make matters worse, the virus has caused a massive global asset dislocation, breaking down traditional relationships between currencies and interest rates, stocks and bonds. If our experience from the global financial crisis is any guide, the OTC derivatives world could be about $25 trillion short on margin.
More than a decade ago, the scramble for cash wiped out as much as $36 trillion, or more than half of the market value of global equities. So far, the coronavirus has cost global stocks about $26 trillion, or roughly 30% of their market value, from their late-February peak. So you could argue there’s a long way to go.
It’s laudable that the Fed is acting fast. But unlike in China, it can’t order banks to stop issuing margin calls or boosting margin requirements. Given how light the provisions have been, it’s only natural that banks will tighten their risk controls.
From risk parity strategies to statistical arbitrages, the coronavirus is unraveling the most sophisticated of trades. This is a reminder that there’s only so much hedging we can do. Today you’re in, tomorrow you’re out.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. She previously wrote on markets for Barron's, following a career as an investment banker, and is a CFA charterholder.
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