Two years ago, Ruffer's investment chief Henry Maxey promised us a full-blown liquidity crisis as the Fed tightened its monetary policy. All we got was a bunch of stupid US banks embarrassing themselves.
In the British asset manager's latest annual report (which came out last week, but we've only gotten around to reading it), co-CIO Maxey revised his 2022 forecast and considered whether the threat had been “averted or merely postponed.” You can probably guess the conclusion:
We don't know exactly when the next flood of illiquidity will hit markets, but when it does, the financial storm will be described as “shocking” and “out of the blue.”
In fact, Maxey believes the risk of a liquidity shock triggering a 1987-style market collapse is greater than before, due to some “emerging features” of the financial system that Ruffer's co-CIO believes will magnify any shock become.
What all of these developments in financial market architecture have in common is that they are likely to increase short-term liquidity shortages and price volatility. This is important because a lot of money today is managed systematically, with exposure to risky assets automatically scaled according to volatility and price trend signals. And if you include money that is not systematically managed but is effectively managed through retrospective, volatility-based risk metrics, that probably makes up the bulk of the asset management industry. So when liquidity, correlation and volatility become an amplified feedback loop and this disrupts price action, huge selling flows can be triggered. And today capital flows seem to be more important than fundamentals.
Let's go through them quickly.
The “run to RRP” risk
To better manage interest rates in the era of excess reserves, the Fed introduced a new tool called the Overnight Reverse Repurchase Facility (O/N RRP).
In short, the Fed sells a bond from its portfolio to investors while agreeing to buy it back the next day at a small premium. Essentially, it's like the Fed borrowing money overnight or investors parking it at the Fed for a tiny interest rate. The amount of money stashed in the EIA has declined sharply as the Fed has reduced its balance sheet and money markets have found better opportunities elsewhere.
But Maxey believes this could abruptly reverse if investor sentiment suddenly falls, making the RRP look very attractive to everyone and draining money from financial markets in general.
The interest rate is five basis points above the lower bound of the Fed's interest rate band, which will look very attractive as investors become fearful of downside risks in risky assets and drive up the price of risk-free government bonds.
. . . There is a tipping point at which the trend towards cash becomes self-reinforcing. In the event of a serious financial crisis, central banks would likely cut interest rates, but the aggressive rate cuts required are likely to be reactive rather than preemptive.
The multimanager universe
FT Alphaville has already written extensively about the growth of multi-strategy/multi-manager hedge funds, their ever-increasing market presence, the rise of copycat strategies and how returns outside of the top players are actually fading.
But Maxey really isn't a fan of pod shops either, calling them a “massive moral hazard machine” that will likely be one of the main culprits in the next crisis. We will quote here at length, with emphasis from Alphaville below:
The multi-strategy hedge fund model becomes a victim of its own performance. This model distributes capital across many independent portfolio manager “pods”. It then hides unwanted risks, increases leverage, and aggressively manages capital allocation across these pods using stop losses. The long-term historical performance of these funds, particularly the blue chip funds, has been breathtakingly impressive.
. . . As a result, these strategies now collectively manage between $300 billion and $600 billion, averaging three to five times leverage. To keep up with growth, there was aggressive competition for talent and aggressive fee increases. This includes the infamous pass-through model, which can result in performance fees being paid to individual pods even if the overall fund has not achieved positive performance.
This has become a massive moral hazard machine. Individual portfolio managers are incentivized and expected to maximize their risk budget in the hope of collecting performance fees. If strategies don't work or traders get stopped out, they can generally find another spot in another fund without too much difficulty. Customers bear the entire risk and most of the costs. It is the reincarnation of Wall Street's proprietary trading desks in asset management, with inverted incentive structures, without the same regulatory oversight and with unfortunate stop-loss risk management.
. . . Some of the strategies used by these players, such as dispersal trading, are now overcrowded. If unwound, they could very quickly reverse a market with low correlation and low volatility. Something similar happened in August 2007 – a fire-sale liquidation of quantitative portfolios that exposed systemic risk in this part of the hedge fund industry.
Portfolio insurance – a dynamic hedging strategy based on stop losses designed to allow pension funds to “safely” maintain a higher equity allocation – was considered the culprit of the 1987 crash. It wouldn't surprise me if multi-strategy hedge funds would be similarly vilified after the next crisis.
Zero-day options
Maxey seems a bit more optimistic about the 0DTE phenomenon, but is instinctively nervous (fair enough) considering how hectic it has become.
My concern is less that this ecosystem is now inherently risky. It's more about how it interacts with other parts of the market during a period of stress. The potential for toxic combinatorial chemistry concerns me most. For example, in times of financial stress, various actors may attempt to use this market to reduce risk, thereby disrupting the normal equilibrium of the market. Or stress could change the behavior of existing market participants.
Central clearinghouse
Another FTAV favorite. If you don't spend at least part of your day thinking about CCP, we can't be friends. Maxey's concern is less about whether too much risk has been pooled in clearinghouses than that the move away from bilateral derivatives has already mechanized pro-cyclical variation margins.
Since the financial crisis of 2008, there have been efforts to carry out as many bilateral derivatives transactions as possible – e.g. B. Interest rate swaps – to central counterparties (CCPs) to reduce counterparty credit risk concerns in stressed markets. These efforts have entailed various risks. In particular, margin requirements tend to be procyclical, meaning they can increase during times of market stress. This can lead to a liquidity squeeze as market participants have to sell assets quickly to meet margin calls.
Salaries have gone wild
An eternal classic since the flash crash in 2010. What is remarkable, of course, is both the frequency of small, inconsequential flash crashes since then and the lack of really big catastrophes. Not that Maxey is reassured.
We have already seen algorithmic market making fail under stress. While it has received some attention, it remains a feature of markets. Algorithmic market making improves liquidity when markets are functioning normally, but impairs liquidity during extreme events.
. . . If the liquidity supply is lost due to unusual market behavior, you have a reinforcement mechanism – one that is much faster than human specialists. Today, as we saw in the case of Silicon Valley Bank, runs happen much faster than anyone could ever have imagined in the past.
The overall effect, according to Maxey, is a tightly coupled financial system that is dangerously sensitive to increasingly pro-cyclical liquidity dynamics. As a result:
People often think that financial disasters occur because crowds of people panic as the emotional pendulum swings from greed to fear. The next market sell-off will be much more mechanical, mathematical, precise and faster. Regulators and policymakers, on the other hand, are human – their response times are slower because decisions are made by committee.
I agree with this argument as I have previously written ad nauseum about how algae has changed the rhythm of markets; the dangers of multi-managers; why shocks are becoming larger and more sudden; how a “volatility virus” has infected the markets and the theory that “liquidity is the new leverage” etc. etc.
All in all, I'm a little less worried about most of these factors than I was three to four years ago, for reasons that will probably warrant a longer, separate post someday. But it's nice to see someone playing the classics that are still worth listening to.
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