Risk from Open-ended Bond Funds, BIS warning

The Cassandra of the markets is not heard, until it is too late. Maybe the BIS is overly-cautious but given the enormous growth in all types of investments the risks arising from a sudden turn in market sentiment are quite substantial. The bear markets of the Seventies could be digested in an orderly basis, apart from serious settlement problems that stemmed from the large rise in transaction volumes. But markets took the massive declines in their stride and nobody ever even thought that the financial system was at risk.

Now - as with the Covid Virus - panic is always in the air if there is the slightest risk of a substantial drop in asset prices. But while this may be overdone there is one risk that is neglected in my view: are margin levels throughout the financial system really able to cope well with a sudden sell-off of, let's say, 20-25 percent? It did happen in 1987 and fortunately that 'blip' got reversed more or less instantly. But now - when volumes are a multiple of those in 1987 - how would the system cope? The desaster that hit Credit Suisse and others when margin was insufficient earlier this year could be played out on a much much larger scale!

BIS Quarterly

Archegos just a warning of things to come

Archegos just a warning of things to come, and it will be ignored! But how many Risk managers are preparing their business for a 1987-style market 'surprise', i.e. a near-instant 25%+ move in prices? Are the clearing houses, prime brokers, margin clerks really set up for this type of 'black swan' event? Markets are much bigger then in 1987 when bond issues of 1 billion were the rare exception and the derivatives market was in its infancy. And we don't even want to think of the break-up of the Euro (my suggestion - if you hold any Euros make sure you are not left 'naked' when it happens).

Credit Suisse troubles due to wrong Leadership Development

Media Pundits and Deal Makers are keen to give free advice to Credit Suisse - sell this, spin off that - especially with reference to its Asset Management unit. But one thing should not be forgotten: there is no clear rationale against combining Retail, Investment and Private Banking and Asset Management as JP Morgan demonstrates. What is required, however, is superior management, and that means having the right people in charge. This means not only hiring potential saviours or mercenaries from outside but creating a HumanResource strategy that develops and fosters talent from the bottom up as demonstrated by GoldmanSachs. Neither the Chairman nor the previous CEO had any proper training as a banker. Head of Risk Management had no previous trading experience or appropriate qualification for the role.

Hedge Fund blows up - where was Citi's risk management?

If the lenders - in this case Citigroup is quoted - of liquidity don't manage their risk and losses result it is easy to blame the hedge fund. Careful monitoring of exposure should have prevented this loss quite easily.
(27-Mar-2019)
Hedge fund blow-up costs investors and Citigroup

Super High Margins required on Bitcoin Futures

In my opinion the collateral required to back up futures trading - but also all over-the-counter derivatives trading - is way too low and not sufficient to withstand a market crash like the one in October 1987 or during the GFC (Great Financial Crisis).
2%, even 8% margin as suggested in this article are never going to be sufficient when markets move 10, 20 per cent of more within days.
The outcome can only be described as truly catastrophic, not only for market participants, but for society and the economy as a whole. It would drive a stake right through the heart of Capitalism.
Why Interactive Broker's Founder fears Bitcoin Futures (Barron's, Pay Wall)

Diamonds are Forever?

Lending ONE BILLION against some baubles supposed to be in envelopes or safes? NUTS! Did they never hear about the Great Salad Oil Swindle in the early 1960's? What do these risk managers do? Do the 'Elite' Business Schools teach them the basics?
https://www.bloomberg.com//news/articles/2017-09-07/how-standard-chartered-lost-400-million-on-risky-diamond-debt

Soothing Words about ETF - But Liquidity disappears when we need it most

The market does provide super liquidity that one could never imagine in the past. But when the music stops there will NOT be enough chairs! This type of complacency makes a major debacle even more likely. How many (highly paid) risk managers are really prepared for nearly instantaneous price changes of 20-25 % in all major markets? Tiny slivers of margin will just not be enough to cushion the blow, esp when some potholes open up and a player (or players) fail.
Junk Bond ETFs Are the Future. That's a Good Thing. - Bloomberg

Outsourcing without limits?

Should national and supranational regulation allow the unconstrained outsourcing of vital enterprise functions? Information Technology is no longer a low skill 'back-office' job but a vital ingredient of today's business. And this applies more than ever to the finance industry where security is more important than in most other lines of business.
Job-Spirale nach unten: First London, dann Zürich - Inside Paradeplatz

Untested Robo-Advisers Are Becoming a Big Market Risk - Bloomberg View

Assets under Management by Robo-Advisers are not yet that large. But when they are in the hundred of billions it will create the mother of all panics. The programs behind them - in addition to 'sophisticated' quant funds - will all rush to the exit at the same time! Sprinkle a few billions of ETF into the mix and the fun can start! No amount or margin/collateral will be able to cope with the resulting price changes. As I often said in this blog - near instantaneous price moves of 20-25% have to be expected. Remember October 1987! It DID happen, and that was at a time when overall volumes and assets where quite a bit smaller.
Untested Robo-Advisers Are Becoming a Big Market Risk - Bloomberg View

Loan Losses incurred by Banks

One has to wonder how banks manage to incur horrendous loan losses in the first place. While it is sometimes said that the only safe loans are extended to borrowers who do not need them it should be foremost on any banker's minds to make sure that loans can be repaid.
Apart for cases of fraudulent collusion between lender and borrower (unfortunately not as rare as naive observers assume) the source of loan losses is larger than can be explained with excuses such as 'unfortunate business conditions'.
A good example is the case of the staid Banque Cantonale de Geneve which in my opinion is straying too far from its area of competence. Financing a commodity trade involving Nigerian transactions is not something you expect a Swiss Cantonal Bank to get involved in. Forensic investigation into cases of loan write-offs would in most cases demonstrate that simple rules of common sense were absent in the decision making, - not only by the bank officers directly involved but all the way up the hierarchy of the institution.

Deutsche Bank - enough own goals to win any competition

It will be interesting to see how much longer the chairman of Deutsche Bank's Supervisory Board will be able to cling to his seat. The number of own goals at DB is growing remorselessly, the person at the top of the management pyramid must certainly take a lot of the blame. Having worked at Goldman Sachs used to be a badge of quality, but that was a long time ago. Nothing but a 'Grab as much as you can' Culture has survived the IPO and Paul Achleitner's handling of affairs at Allianz Insurance was also not exactly crowned by success (Dresdner Kleinwort may ring a bell).

Illiquid Bond Markets? Brace Yourself!

Not much has to be added to my post from October 2014. Maybe the move to automated bond trading has accelerated a bit, but I would not expect that to be of any help when markets become stressed. But the issue is not off the table, and given the voices of prominent market pundits it is obvious that no one really knows what will happen if a major bear market in bonds arrives. But investors should remember that bonds are a conservative investment, or at least they should be. That means investing with a view to hold to maturity, so there is no real need for liquidity.

From October 2014:

Recently there are more and more reports about a perceived lack of liquidity in secondary bond markets.

For example Fund Traders dig deep for bonds (WSJ, Paywall)

Most Commentators blame the tide of regulation that has forced market makers to drastically reduce their bond inventories.

This may be a valid point but one should not forget that some other aspects could be more relevant.
The bond trading business has expanded enormously during the past 20-25 years. Until 2007/08 volumes and staff levels increased to what in retrospect can only be described as unsustainable levels. Some retrenchment was inevitable, with or without added regulation. This naturally has an effect on the volumes that the dealer community can handle.

Technology may play an incremental role but many more complicated transactions still have to be done over the telephone, albeit with the aid of messaging or email services. Full automation is still a distant prospect, especially when there are tens of thousands of different bond issues outstanding. 'Do you want to kill the goose that lays the golden eggs?' asked the head trader of the erstwhile Credit Suisse White Weld in the late 1970s in a note to a colleague who wanted to introduce technology into the bond trading business. In my opinion he still would not need to worry too much.

The level of interest rates has - and will - have to play an important part in the lack of liquidity. The big bull market in bonds has played itself out, rising markets create turnover. At best markets from now will move sideways - creating less and less profitable trading opportunities. At worst they will enter bear territory and declining bond prices traditionally mean lower profits and lower volumes. Only the best traders will be able to prosper in a climate of fear and pessimism.

The explosion in the amount of outstanding bond values and the corresponding expansion of the buy-side (who would ever have thought that a fund manager less than 30 years old would control billions in assets?) make it virtually certain that there will not be enough liquidity to allow a smooth exit through a (very) narrow door when markets turn. Is any trading venue going to be able to take the other side when the likes of Pimco or BlackRock want to implement a drastic shift in their investment strategy?

So the old saying holds: Markets will fluctuate, this will create opportunities for those who are a step ahead of the crowd. Expect sharp moves and review your risk management process to be able to cope with extreme volatility if and when it arrives - as surely it will one day.

Being a 'Global' Bank brings extra Risks

One has to wonder if being a 'Global' Bank is really an intelligent business proposition. It requires Superman/woman to manage far-flung empires and activities that can span more disciplines than any normal human can realistically be expected to fully understand. And a particular risk factor are differences in business culture that senior management - be it located in New York, London, Frankfurt, Zurich or Tokyo - can hardly be expected to appreciate to the extent that would be required. Deutsche Bank lending money to build another hotel/casino in Las Vegas? Citigroup lending money secured by warehouse receipts in Chinese Ports? An Austrian Bank lending money to a steel business in Russia? Do these activities make sense or would concentration on a geographical area one understands and is familiar with be more profitable in the long run?