This Is the End

RICK BOOKSTABER

Markets, Risk and Human Interaction

October 30, 2017

The Vanishing Pavilions: Gutting Government

October 30, 2017
What will be the longest-term damage of the Trump era? A strong, principled leader will restore some semblance of decency and ethics. Foreign governments might view this period as a bad dream, or an outlier event that veered the U.S. away from a now-returning normal. The anti-scientfiic and pro-industry biases in the various departments and agencies can be rectified just as quickly as they were enacted.

There has been plenty of discussion of where the long-term damage might be on the world stage; the new path governments and businesses are taking toward China -- this might have been inevitable, and Trump has been nothing more than an accelerant; the move toward center stage of China and Germany as world leaders.

But within the U.S. the long-term damage will be more subtle. It will be the loss of the oral tradition, of institutional memory, in our government. That is, the loss of processes and interactions that are conveyed by word of mouth and by example as opposed to by written instructions.

The U.S. Treasury is a case in point. I worked there after the financial crisis, helping draft the Volcker Rule, setting up the risk management structure to get information up to the Financial Stability Oversight Council, and building an agent-based models to help assess financial instabilities. I just went back to the Treasury for the first time since the start of the year to find that is has been gutted. This is not something that is on many people's minds, but it has implications that will be felt far beyond the time that a new administration comes on the scene that wants to return the department to a more normal state.

The reason, in a nutshell, is that what the Treasury does -- and what, for that matter the State Department, a department that is in even worse shape, does -- is not in any manuals. It is set on a foundation of what might be called oral tradition. People know how things work, how to get things done, and if the keepers of the oral tradition leave, it all has to start back up from scratch.

When a new administration comes in, it is the normal course of business for all the appointees to be replaced. Generally the new appointees come from outside government, and have not had previous experience in the Treasury. They rely on the staff, which mostly stays from one administration to the next. They know the process for getting things done, for developing and administering policy.

The Treasury is not a regulator per se, but it tends to be the center of communication -- and the referee when necessary -- for the agencies that do have regulatory authority: the SEC, FDIC, CFTC, etc. There is a process that has been honed over many administrations for doing this job, for acting as the central switchboard for dealing with financial issues. What happens when the switchboard operators walk out the door, and there is no operation manual to leave behind?

October 19, 2017

The Crash of 1987 -- Happy 30th Anniversary

October 19, 2017
I was at the center of the October 19, 1987 stock market crash, when the U.S. equity market dropped 20% in a single day. The second chapter of my book, A Demon of Our Own Design recounts my experiences during the 1987 Crash, and provides an explanation of what went wrong.

The essence of the problem was a programmatic positive-feedback strategy, namely, the dynamic hedging program of portfolio insurance, coupled with the time disintermediation between the speed of the index futures market in Chicago and the more deliberate pace of those in the equity market in New York.

This is not so different structurally from what we have now with the time disintermediation between the ETFs and the underlying cash markets in the less liquid markets -- which is not observed when we have two-way flow -- coupled with various positive-feedback strategies such as volatility targeting and various flavors of what are essentially momentum strategies. Or other structural issues within the current financial system.

So, below is an edited version of Chapter 2 of A Demon of Our Own Design.

(If you have arrived here by going to my blog rather than to this post specifically, you need to click on the post to see the excerpt.)

Excerpts from A Demon of Our Own Design, Chapter 2: The Demons of ‘87
Richard Bookstaber
....

Portfolio insurance was commercially developed by two Berkeley finance professors, Hayne Leland and Mark Rubinstein. With John O’Brien, their marketing partner, they founded a management company, LOR, in 1981 to sell their technique. Within a few years it was programmed for action in the computers of some of the largest investment firms in the world. At the start of each day LOR sent their portfolio manager clients hedging instructions based on their runs of the Black-Scholes model. The managers did the hedging themselves.

In practice, the equity manager initiated a hedge against his equity portfolio, usually using the S&P 500 futures contract as the hedging instrument. ... As the portfolio increased in value and moved above the floor price, the hedge was reduced, allowing the portfolio to enjoy a greater fraction of the market gain. As the portfolio declined in value, the hedge was increased, so that finally, if the portfolio value fell well below the floor price, the portfolio was almost completely hedged. Thus the portfolio was hedged when it needed it, and was free to take market exposure when there was a buffer between its value and the floor value defined by the exercise price.

....

Since the basic option technology for portfolio insurance was well known, other firms followed LOR into the market to provide this hedging advice. I spearheaded the effort at Morgan Stanley.

....

This activity engulfed segments of the firm that rarely related to one another. I was in the Fixed Income Division marketing an equity product to investment banking clients and then managing the resulting programs as a fiduciary in Morgan Stanley Asset Management. I ran programs for some of the firm’s blue chip clients, including Chrysler, Ford and Gillette. This strategy was considered to be at the leading edge of market innovation; rather than buying an existing security, portfolio insurance was ushering in the brave new world of creating synthetic instruments on the fly through dynamic trading strategies.

....

The equity market was ripe for the promise of portfolio insurance, because there was much to insure. From 1982 to its pre-Crash peak in August 1987 the Dow Jones Industrial Average went on a bull run that nearly tripled the index. The U.S. economy cooperated providing five years of uninterrupted economic expansion. By 1987 the market was moving forward at an exponential rate; from the start of the year to late August the Dow rose more than 40 percent.

By mid-October, though, the promise of portfolio insurance began to look like a very good idea. From the close on October 16th, the market seemed like it came from a totally different world. The Dow had already fallen nearly 500 points from its August high of over 2700, washing away nearly half the year’s gains. And then decline became free fall. The week preceding the 19th, the market dropped 4% on two separate days: On Wednesday, October 14th the Dow dropped by a one-day record 95 points, and on Friday the 16th a new record was set with a drop of more than 100 points.

On the trading floors at Morgan Stanley, equity trading turned into a spectator sport. Throughout the latter part of that week fixed income traders and salesmen filtered down the stairs from the 32nd floor to the equity trading floor, standing around to watch the frenetic scene. The equity markets benefited from the built-in structure of having listed exchanges for stocks, futures, and options, and usually were much calmer than the fixed income markets, where every bond the desk purchased had to be taken out to many clients to find a new home. The crowds watching this train wreck amplified the crisis mentality. This finally led Anson Beard, the head of the Equity Division for Morgan Stanley, to post signs declaring that “Unauthorized Personnel Loitering in the Trading Area are Subject to Immediate Dismissal.” That took care of the riffraff, but the firm’s Managing Directors still found their way to the floor.

And if they were on the floor on Monday, the 19th, they got an eyeful. The open of the futures market at 9:00 a.m. that day started a cascade of selling. A half hour later, the New York Stock Exchange opened to an apparently insatiable demand to sell stocks as the NYSE tried to keep pace with the selling of S&P futures in Chicago. The imbalance of buying and selling demand was so severe that many stocks did not even open, and the rapid decline in the price of the stocks that did, coming on the heels of the previous week, left most investors frozen in their tracks. By the end of the day the market had suffered its worst one-day percentage drop in history, down over 22 percent. The S&P futures fared even worse. The program trading that normally linked the futures’ intraday prices to the S&P cash market could not keep up with the selling demand in the futures pit, so the futures dropped even further – nearly 29 percent. Overnight the panic spread around the globe to other equity markets. In the 18-hour period after the New York market open, wealth equal several years worth of global GDP was wiped from the face of the earth.

The postmortem of the 1987 Crash is filled with reams of reports that have tried to fit it into the efficient market, information-based mold of contemporary economic dogma. ... But none of the analysis stood out, either individually or in aggregate, as the source for any sort of major rethinking of the market. The 1987 Crash simply was not the result of a rational reaction to new information. What sort of information could have led the market to drop more than 20 percent on the 19th, jump 12 percent early the next morning only to fall another 10 percent in the following few hours? Nor was it a matter of herd psychology. The moon and stars did not align to lead broad segments of the market to wake up Monday morning and decide to dump their shares.
In fact, a select and concentrated set of firms generated the selling demand on the 16th and the 19th.

...

It didn’t take a genius to see that the source of the Crash was market illiquidity, illiquidity that was the unintended by-product of the new and wildly successful portfolio insurance strategy—and one that I had helped to popularize and implement.

...

If a hedge cannot be readily adjusted, then obviously all bets are off, and for a hedge to be properly executed, the hedging instrument has to be liquid: some counterparty needs to take the other side of the hedge.

If one small portfolio uses this sort of stop loss strategy, liquidity will not be an issue. If everyone in the market is trying to do it, it can become a nightmare, a little like everyone one a cruise ship trying to pile into a single lifeboat—it won’t float; neither did the market. And that, in a nutshell, is what happened. On Monday morning, October 19, 1987, everybody who was running a portfolio insurance program pulled out the computer runs from Friday’s market decline. The record drop on the previous Friday had caught some firms flatfooted, and on Monday morning they had to make hedge adjustments to the decline, pouring sell orders into the S&P futures pit by the truck full. But other such trucks had started down the road a week earlier, barreling into the option and futures markets from a distant part of the equity trading floor that was run more by rumors and personal contacts than by computers and mathematical models.

...

By Monday morning everyone was lined up at the gate to be the first to get orders filled. Portfolio insurance firms sold nearly half a billion dollars of S&P futures, amounting to about 30% of the public volume. The futures prices dropped precipitously, and the stock market had not even opened. About 15 minutes into the futures market decline, we started to see inexplicable activity from an unexpected quarter, cash-futures arbitrageurs. Their poorly executed attempts to capitalize on the apparent chasm between the cash and futures prices would be the red flag that triggered the stampede in the NYSE.

The futures desk on the equity floor had one junior member whose job throughout the entire trading day was to sit with a phone cradled on his shoulder. On the other end of the line was someone whose job during trading hours was to watch the pit and relay the latest trade or bid and offer to the guy on the desk. When a new level was reached, or unusual activity occurred, he would announce it in a monotonic cadence that was thankfully blended into the background noise of the trading floor. But on the morning of the 19th we were all ears.

The cash-futures spread was reaching levels that were many-fold what was generally needed to make an arbitrage worthwhile, so a host of cash-futures traders began to bring their orders to our program desk. The only problem— and in our minds it was a big problem—was that the stock market was not even open yet. The discrepancy these traders were observing was based on the current futures price versus the price of the stock market on Friday’s close. The traders were basing their actions on stale data; there could be no telling where the stock market would actually open. They put in orders to sell at the market price at the open, under the assumption that the open would be close enough to the Friday close to still make the discount in the futures contracts a profitable trade.

That was a big bet, and a far cry from the relatively low risk enterprise of the usual cash-futures trade. And in this environment, it was even more risky because when the stock market did open, it was an absolute lock to open down. The execution of the program trade would then be complicated by the downtick rule, which proscribes short selling a falling stock. The arbitrageurs wanted to buy the futures and sell the stocks short against them. If the market is in free fall, up-ticks are few and far between, and there are many short sellers trying to squeeze in their execution. It can take a long time to get a trade off. In the meantime, the long futures position is being held unhedged. If the market drops, the trader loses.

The portfolio insurance hedgers found the other side of the market in the cash-futures traders and market makers, and these traders in turn were depending on the stock market to hedge out their bets in the futures. In effect the cash-futures traders were taking the market impact from the futures pit and transmitting it back to the individual stocks on the NYSE. By buying the futures and then selling the individual stocks, the individual stocks would finally “feel” the impact that was being implied by the intense selling pressure in Chicago. In theory this arbitrage is a natural market mechanism for tying the cash and futures stock markets together, and up to Monday the 19th it worked smoothly. But on the 19th the speed and magnitude of the normal smooth waves of selling metamorphosed into a tidal wave that rushed in from Chicago. It was more than the stock market could absorb.

...

Program traders and arbitrageurs take positions on the S&P contracts trading in the futures pit while simultaneously taking opposite positions on the individual stocks that comprise the S&P on the NYSE. When the S&P futures contract sells for less than the price of the basket of the individual stocks in the S&P, then the cash-futures arbitrageur buys the S&P and sends in orders to sell the individual stocks. If the price difference is greater than the transaction costs of doing this trade, then they make an almost certain profit. This trade effectively transfers the stock market activities of the futures pit to the individual stocks on the NYSE. It is here where things broke down in 1987, and broke down for a simple reason: stocks are not as liquid as futures.

The problem was that the traders in the S&P pit are mostly market makers, jammed together gesticulating and shouting out orders in hopes of scalping a few ticks. They thrive because of their quick reactions to the market and their speed of execution. By contrast, equity investors of the day who frequented the NYSE were not particularly focused on speed of execution, nor were they concerned with the minute-by-minute movement of the market. As the futures traders reacted to the market and the cash-futures arbitrage traders transmitted that activity to the NYSE floor, the flow hit a wall. The specialists could not unload their inventory into the stock market as quickly as the selling was shoveled over to them from the futures pit because their clientele was not glued to their screens, ready to react in mass. The futures market was operating in broadband and the NYSE on dial up.

The specialists tried to elicit more buyers by dropping the price, but there was a limit to how much more buying interest they could attract. No matter how quickly the price was dropped, the decision making by the equity investors took time; not all equity portfolio managers sat glued to their screens, and unlike the twitch-quick futures pit traders, they made portfolio adjustments only after reasoned consideration. With their limited capital the specialists were not willing to wait for the process to unfold, and their increasingly aggressive offers ended up backfiring. Prices dropped so violently that many potential buyers started to wonder what was happening and backed off completely. In pushing so hard, the specialists’ actions became cause for suspicion, which then fed and finally betrayed their own panic. The root dynamic was time disintermediation—the time frame for being able to do transactions was substantially different between the futures market and the equity market, yet these two markets had been linked together through market arbitrageurs.

On our trading floor we could see that the drop in price was not having the desired effect. In fact, it was scaring investors away. One of our institutional clients in Boston was bullish on IBM and had discussed strategies for adding more of the stock to his substantial portfolio. His salesman tried to grab him as IBM started to tank, but he was off his desk in a meeting. A second call could not locate him. We could imagine him heading off to grab some coffee and leaf through his morning faxes, unaware that the markets had begun to slide down around him.

Back at the NYSE, a day’s worth of activity had passed in what seemed to be 10 minutes. The specialists were starting to panic. A flood of sell orders was coming in from the other side of the cash-futures arbitrage and there were no where near enough buyers coming in to take them off of his hands. With price is his only tool, the specialist dropped IBM another point, and then two more points, to try to dredge up some buying interest.

The portfolio manager in Boston finally got back to his desk, saw the beating IBM was taking on the open and gave us a call. If IBM had been down a half point or a full point, he would have put in an order, and would have been provided the other side of the trade that the specialist needed. But with IBM and other stocks in freefall he hesitated to buy, waiting instead to get a read on what was going on with IBM and the market generally. As he spoke with us, he was interrupted and returned to announce that because the downswing was accelerating, the fund’s director of equity investments asked that no trades be executed until all the portfolio managers could meet to assess the situation.

Since this client worked for an asset management firm with a long-term investment horizon, he could put on a position just as easily tomorrow as today. He watched the market’s downward cascade with something likely approaching detached curiosity. As the markets fell further, from 5 to 10 to 20 percent, he likely felt some panic. But for the moment he and many of his counterparts were on the sidelines. Meanwhile for the specialist, more shares piled up in inventory with each passing minute. Other specialists were faced with the same onslaught and prices fell all around, so now the IBM specialist found that eliciting buyers was even more difficult, since he had to compete with the other falling stocks for attention.

It is not long before the offer price for IBM, Big Blue, the bluest of chips, was down 10 points from the open. The result was a disaster. The potential liquidity suppliers and investment buyers were being scared off by the higher volatility and wider spreads. And, more importantly, the drop in price was actually inducing more liquidity-based selling. With each point drop, the portfolio insurance programs triggered more selling, and the portfolio insurance managers threw more sell orders into the futures market. Because of the dislocation between the hair-trigger execution of the futures and the ponderous decision making on the cash equity side, compounded by the insufficient capital of the specialist to bridge the gap between the incoming supply and the timeframe of the potential buyers, the specialist dropped the price of IBM too quickly. The potential suppliers who could have taken on the selling demand – and who would have been willing to do so with modest price concessions, had the move been more gradual – got spooked, and the portfolio insurance hedgers demanded even more liquidity than they would have otherwise.

A price drop is normally the dinner bell for buyers. So precipitous drop should have had traders licking their chops. But it doesn’t work that way; if prices drop too far and too fast, it sends the wrong signal to the potential liquidity suppliers. Rather than taking the drop as an indication of liquidity demand, they viewed it as – or at least heavily weighed the possibility—that the fall was a result of some new market information. In classic “market for lemons” style, they viewed themselves at an informational disadvantage, and elected to stay out of the market.

Replay this mutual fund manager’s reaction over many times, and you basically have the fault line of the crash of 1987. Selling demand increased as prices dropped because of the pre-wired hedging rules of the portfolio insurance programs. Supply dried up because of the difference in time frames between the demanders and suppliers. By the time equity investors could have reacted to the prices and done some bargain hunting the specialists had moved prices so precipitously that these potential liquidity suppliers were scared away. The key culprit was the difference in liquidity because of the different trading time frames between the demanders and the suppliers in the two markets. If the sellers could have waited longer for the liquidity they demanded, the buyers would have had time to react and the market would have cleared at a higher price.

...
BAD GAMMA

The problems created by portfolio insurance were compounded by a feature of the option strategy being implemented. When the portfolio is far from the floor price, the hedge is small and changes in the value of the portfolio require only a small adjustment in the hedge. This is because the position has a low likelihood of needing to be protected and because there is a lot of room between the current portfolio value and the floor value to ramp the hedge up. As the portfolio value drops and nears the floor, the size of the hedge increases and the amount of adjustment that is made for any change in the market increases as well. Another way to think about this is that the change in the value of the option being created (because that is what the hedge is doing) with a change in the underlying security (in this case the market) varies depending on how far the option is from the exercise price. In the mathematics of option theory this change in the amount of the hedge with a change in the price is called the option’s gamma. As the market declined and brought the portfolio insurance programs closer and closer to the floor, the impact the portfolio hedges, bad as they were early in the day, got worse and worse.

Nothing could change the momentum. The lack of program trading caused the discount in the price of the futures relative to the cash equity market to reappear.

...

In the midst of the market disconnect, the inability to get timely execution, the vanquishing of many of the liquidity providers, and the fears of a total break in liquidity through an early market close, the portfolio insurance programs continued robotically to spit out sell orders, oblivious to anything but the current market level and the mathematical requirements of the hedge. In the last 75 minutes of the trading day, the DOW dropped by 300 points, three times as much in a little over an hour as it had in any other full trading day in history.


THE PHYSICS OF THE MELTDOWN

I spent the week chained to my desk, my eyes frozen on the Quotron screen as I struggled to maintain the hedges demanded of the portfolio insurance programs I ran. Prices were moving all over the place, swinging more violently minute by minute than they usually did in an entire day, and the spread required to buy or sell the S&P futures – still the most liquid instrument in the equity market – was a dollar or more, 20 times normal. I had to weigh the implications of holding off on a hedge adjustment on the one hand with the incredible transaction costs in executing in the market on the other.

The huge volatility of the market broke down all but the most fundamental relationships between the market securities. The usual day-to-day world where investors cared about subtleties like corporate earnings or analyst forecasts dissolved as the energy of the market was turned up. All stocks moved together; if it was a stock, it was sold. The market hardly differentiated between domestic and foreign, small cap or large. It was like plasma physics: As matter becomes hotter it becomes less differentiated. The forces that bond atoms together in the form of molecules are overwhelmed, so that rather than having a myriad of different substances, we have the elemental building blocks of the atoms. Turn up the heat further and the atoms themselves are melded into plasma, positively charged ions and negatively charged free electrons; matter in its most uniform and non-differentiated state, no longer hydrogen atoms and oxygen atoms, just a seething white-hot blur of matter.

Just as high energy physics creates a state that is no more differentiable than to say that it is matter, so the high energy in the financial markets created a world where securities were no more differentiable than that they contained risk.4

This melding even extended beyond stocks. High yield bonds, which usually tracked fairly closely to Treasury Bonds, suddenly became simply high-risk bonds, and traded just like stocks. Meanwhile, Treasury Bonds, the anti-matter of the world of risk, were grabbed in the flight to quality, and traded up in price. This behavior demonstrates a characteristic I have observed and expounded repeatedly: as the market moves into crisis, the absolute value of the correlation of assets approaches one. The problem is you cannot always predict ahead of time if the correlation will be one or negative one. One asset might end up hedging another, or it might end up doubling your exposure.

...

The surprise for Morgan Stanley was that our biggest losses came not from equities, but from high yield bonds. The flight to quality moved investments away from equities into Treasury bonds, with the result that as equity prices declined, bond prices shot upward. In the aftermath of the 19th, the interest rate on 90-day Treasury bills dropped almost two percentage points to just over five percent and the benchmark 30-year Treasury bond shot up by over 11 points. Corporate bonds did not share in the shift to fixed income; they went south instead.

...

October 19th ushered in, spectacularly so, the context for a type of risk that would embrace the markets in the future. At the root of the Crash was computer-assisted liquidity in the form of rapid, programmed, cash-futures execution, and an innovative analytical products in the form of the option model’s differential equations applied to construct synthetic put options. The market was developing to allow lightning fast reactions while at the same time driving complex innovations in market instruments and strategies that required ever more time for investors to analyze and absorb. This combination of speed and complexity would be the source of many future crises.

October 15, 2017

Can We have an ETF Meltdown?

October 15, 2017
What is the magic that allows us to have intraday liquidity through an ETF on a market that itself trades more or less by appointment? Case in point: the high yield bond market. Or emerging markets. Or just about any bond market short of sovereigns and maybe agencies.

Suppose there is a sudden rush for the exits in the high yield bond market. Those in the cash bonds know the drill. They will put in orders with the bank/dealer market makers. For a while those high yield bond trading desks will buy the bonds and hold them in inventory. But it won't take long for the trading desks to reach their capacity. After that point, they won't be buyers. They will act as agent -- also knows as riskless principal -- and look for someone on the other side of the trade. In the meantime the seller has to bide its time. The point is that on the cash bond side, it is not an intraday sort of a transaction. It can take days to find the other side for the trade. And anyone who is active in the high yield bond market knows that, so they structure their leverage and liquidity accordingly.

However, those in the ETFs by and large have no inkling that this is the way the market for high yield bonds works. As far as they can tell, the ETFs trade like an S&P 500 stock. You put in an order to sell, and you are done in minutes.

The reason there is typically high liquidity in the ETFs is that there is typically good two-way flow. And beyond the buyers and sellers are what are called authorized participants. The authorized participants keep the ETFs linked to the underlying cash bonds. They can create ETFs by buying up and bundling the underlying bonds, and they can take in the ETFs and unbundle them and sell the underlying bonds. In a functioning, two-way market, this all works the way arbitrage does for equities indexes. If the ETFs are at too high a price relative to the cash bonds, they grab the cash bonds to create and sell ETFs. If the ETFs are at too low a price relative to the cash bonds, they buy the ETFs and take the bonds to sell in the bank/dealer market.

It sounds simple, but it can't really be foolproof. You know there must be something that can go wrong when you have an instrument -- the high yield bond ETF -- that is as liquid as water even though the bonds it contains are almost the definition of an illiquid security. There is something akin to trying to cheat the law of conservation of momentum. And we all know that anytime something depends on some notion of arbitrage, things can go off the rails. I was in the middle of the portfolio insurance problems that led to the market crash in October, 1987. I knew all about option theory, but when the market was in free fall and the bid-offer spread for the S&P 500 futures was over a dollar, no one was in the mood to try to keep prices in line by doing delta hedging. Options traded in their own world. Implied volatilities were 80% and higher. The option market went into rotation -- trading one stock at a time throughout the day.

For the ETFs, things can go off the rails if the authorized participants can't do their job. If there is not a two-way market, and if the authorized participants' inventory is filled up with ETFs, and if they see that it will take days to get the bonds off of their hands, at the very time that prices are going crazy, they will be stepping away. At that point there is nothing tethering the ETFs to the cash market. The ETF market and the high yield bond market will each trade as their own thing, based on who needs to sell and who is there to buy. At that point it might as well be one market for Martian gravel and another for Enceladian ice cones.

Sure, that is taking it a little too far. There will be some real money investors who will finally step in and keep things from moving into a totally imaginary world. But for the time being the ETF market will, for all practical purposes, shut down. And, getting to the next chapter in this story, it is the "for all practical purposes" that matters.

A clear-thinking, experienced investor in, say, an ETF on an equity market index or gold or currency will not be bothered much by the failure of the high yield bond ETFs. They will get the point that the high yield ETF was creating a fiction of liquidity when there wasn't any, whereas in these equity and currency and commodity markets the underlying markets trade with pretty much the same liquidity as the ETF. But for many investors, all they will hear is that ETFs are in trouble. In the face of the major market dislocation in which the high yield bond problems are likely to be embroiled, people are already going to be in risk-off mode, and if they smell some sort of structural risk with these "newfangled ETFs" they will sell them, period. And there will be plenty of sources out there ready to spread the view that something is amiss.

And, getting to Soros's theory of reflexivity, the changing expectations that come from people in the market buying into this view means that those clear-thinking experienced investors will get out of these more liquid ETFs themselves. And if the authorized participants are still up for doing their job in those markets, that selling will feed back to drop the underlying markets in equities, currencies, and commodities.

October 1, 2017

Out-there Scenarios: ISIS and Asset Management

October 01, 2017
I break risk management into three levels, Versions 1.0, 2.0, and 3.0.

Risk Management 1.0 is the standard risk management of VaR and the like, where history is used as a guide, and thus where things work if the future is drawn from the same distribution as the past. Any approach that is looking at risks historically, whether using past prices or variance-covariance relationships or leverage numbers or credit ratings; whether using a normal distribution or a t distribution or a gamma distribution or a part of a distribution like semi-variance, is part of this. If the future looks like the past in some specific ways, it works; if the futures deviates from the past it might not work.

Risk Management 2.0 is a reaction to the fact that the 1.0 methods failed during the 2008 crisis. This failure is not surprising or unexpected by most of those working in risk management, because we understand the assumptions behind Version 1.0. But sometimes this was not articulated well when the numbers were passed up the chain. In any case, after 2008 risk management started to depend more visibly on stress testing. I say "more visibly" because anyone doing risk management over the past decades has done stress testing in one form or another. Certainly when there are non-linear risk-return tradeoffs, like with option exposures, it is a standard method. But after 2008 it became de rigor in the analysis of bank risk, for example using CCAR.

And there is Risk Management 3.0, which I won't get into here. It recognizes that a static stress will miss important dynamics that lead to feedback, contagion, and cascades. And it is not something that can be readily addressed with the standard economics. You can check out my book, The End of Theory, or some of my papers while I was at the Office of Financial Research to get more on this.

Here I am focused on what we need to do before we can get to these dynamics: We need to know what is triggering a market dislocation. And we are particularly interested in triggers that are large in either magnitude or in the number of agents that are affected. So even before worrying about the methods for dealing with crisis dynamics, the question to ask is: What can go wrong in a really big way.

I sometimes get at this by starting with something really extreme, and then dialing it back until it can be considered as a reasonable scenario. Reasonable does not mean it is likely to happen, but it also is not "what if an asteroid hits New York" either. Anyway, I want to run through some of the extreme scenarios that I have been thinking about. I'll put one out here and see if anyone responds, either with comments on it in particular, or with others that they are cooking up in a similar vein.

So, Out-there Scenario I: A large asset manager is rumored to be funding ISIS.

Suppose a rumor goes viral that a very large asset management firm is actually owned by, or at least is funding ISIS. This hits all the usual fake news outlets, and is then, of course, bounces into the real news if only as a "there is a rumor, unsubstantiated, making the rounds that...." The result will be large scale redemptions in that asset manager. This will start a downdraft in the markets. It will also lead to questions about other asset managers, and redemptions there as well. The resulting cascade could spread across the markets, erode confidence, and become a major market event.

Now, of course (at least I hope it is obvious) I am not saying specifically that this rumor is likely. But start with this and, as I suggested above, dial it down a bit. The point is, we can come up with scenarios where there can be massive redemptions in some particular major asset manager, and they can be exogenous to anything in the market, and on the face of it might be unreasonable.

One argument against this path to major redemptions hitting the market is that people can redeem by moving their holdings to another asset manager. If they do that there will be no actual selling of assets, and no market impact. This is the way investors will redeem if they continue to want to hold the assets and if they operate with professional aplomb. But the sort of people who would buy into a rumor like this are also likely to simply say, "give me my money", and then figure out what to do after that.

A little footnote: A few years ago the Office of Financial Research did a research study of the asset management community, with the key question being whether the largest asset should be SIFIs (systemically important financial institutions). The report was castigated, especially by the SEC, mostly, I think, because the SEC was honed for inter-agency rivalry. But in any case, no one threw the ISIS scenario into the report.