WMD Old and New Primed for a Market Meltdown

(Bloomberg) -- Innovative financial instruments contribute to every financial crisis.

Portfolio insurance, the practice of using dynamic hedging to limit losses, played a big part in the 1987 crash. High-yield and emerging-market debt, leveraged private-equity transactions, and hedge funds have all had central roles in upheavals, as have securitization, including CDOs, and various derivatives.

In the next crisis, familiar instruments — chiefly risky debt and derivatives, either rebranded or modified — will be prominent. There are record levels of high-yield and emerging-market (some of it now labeled “frontier market”) debt outstanding. Volumes in private equity (once called leveraged buyouts) are high. Securitization and CDOs have re-emerged, including subprime transactions in auto loans.

Banks may be less exposed directly than in the past, but they have significant indirect exposure to these instruments through loans to nonbank financial institutions.

More recent innovations may also cause trouble.

One is the $5 trillion of exchange-traded funds. While ETFs are useful in creating low-cost exposure to an index, in a slump the need to liquidate underlying assets may exacerbate losses, especially in funds linked to less liquid securities. ETFs rely on authorized participants (typically large brokerages) to buy and sell shares to ensure prices reflect the underlying portfolio, eliminating the discount often associated with closed-end mutual funds. Under stressed conditions, that mechanism may not work, disconnecting ETF prices from asset values and spreading contagion.

Another is volatility trading, designed to take advantage of the stability engineered by central bank intervention. This includes trading VIX futures or their OTC equivalents and traditional option-selling programs used by investors. The greater part of this activity arises from quantitative investment strategies, such as risk parity or volatility control, which require regular rebalancing by selling risky assets when prices swing wildly. Overall, the total volatility market may be as big as $2 trillion.

Then there’s the growth of automated trading, which now constitutes about 80 percent of total activity. Underlying algorithms are calibrated to past data, weighted heavily to recent artificially benign market conditions. The performance of these strategies in volatile, falling and illiquid markets is untested.

The recurrent risks introduced by new instruments are straightforward.

The assumption of market liquidity fails repeatedly to recognize that no product can be more liquid than its underlying asset which frequently can’t be traded during dislocations. ETFs and automated trading create a perverse illusion of liquidity in favorable, calm conditions.

Research by the Bank of England found that in times of stress, algorithmic trading provided poor liquidity and inefficient prices, magnifying shocks. In the next crisis, that will be exacerbated by a reduction in the number of market-makers and their risk-taking appetite due to regulatory changes and reluctance to lose capital. Liquidity has also diminished because of market fragmentation.

A related pitfall is that many innovations are momentum-driven and trend-following: They can force buying as prices rise, and selling as they decline. This negative feedback loop is intensified because non-linear instruments or strategies — usually anything with an option-like payoff — require more trading the greater the price moves.

Leveraged investors will themselves be forced to sell liquid assets in a major correction regardless of the price outlook, in order to raise funds for margin calls or redemptions. That creates unforeseen linkages between instruments. The exposure can be gauged by the fact that in early 2018 a relatively minor dislocation in volatility markets spread rapidly to other assets, resulting in global losses of around $5 trillion.

Institutional and regulatory initiatives can’t prevent financial innovation from contributing to new crises.

Consider the reasons. First, investors competing to generate returns take on risk, typically leveraging their positions. They may pick less liquid and opaque sectors, where the dangers are difficult to quantify.

Second, markets display herding behavior, where participants mimic the actions of others driven by the consensus view and the need to avoid poor relative performance. This results in crowded trades, where volumes exceed market capacity. Behavioral economics and neuroscience highlight chasing behavior colloquially, fear of missing out which motivates buying when prices are rising and panicked selling when sentiment turns negative.

Third, there’s a lack of institutional memory. Investors, traders and risk managers who made mistakes in the last crisis are rarely retained. Many current financial market participants began their careers after 2008 and have never experienced a serious downturn.

To paraphrase the comedian Will Rogers’ observation about war: You can’t say financial systems don’t progress in every new crisis they kill you in a new way.

©2018 Bloomberg L.P.