Karen Petrou’s memorandum on fiddling as market risk burns to Federal Financial Analytics Clients.
Karen Petrou On Fiddling As Market Risk Burns
TO: Federal Financial Analytics Clients
FROM: Karen Shaw Petrou
DATE: June 12, 2015
Last week, the CFTC held a roundtable on market risk. What I learned from it is that no one knows what market risk is, how much we’ve got, and how to tell if it’s getting better or worse. We’ve got cool models, but they say little other than when it might be a good time to buy or sell something. But, even if the roundtable couldn’t count the ways to define and measure market risk, I think I know it when I see it, and right now I see a whole lot of it. Too bad regulators at the roundtable professed themselves powerless to do much to forestall it.
The first question to this roundtable was on the meaning of “market liquidity,” a non-trivial risk concept, especially of late. Liquidity, we were told, is the ability to transact in assets without unduly (whatever that means) affecting market prices. However, different assets have different transaction characteristics that lead to different prices. Thus, no one knows whether price movements mean that there is more or less liquidity. For good measure, we learned also that even if one sorted out different asset markets to see how prices move, no one knows what prices are unless or until one or another of them heads for the stratosphere—by which time, of course, liquidity risk is painfully obvious to the innocent passer-by.
The second question at the roundtable was how liquid markets are, despite the fact that all had just agreed that how to measure liquidity is so far unknowable. Unsurprisingly, judging liquidity proved just as hard as measuring it. And, of course, even if we have more liquidity now—whatever liquidity is—that doesn’t mean there will be enough later under stress. Determining how best to handle stressed liquidity risk, given the dramatic change in the role of central bankers in concert with financial-market composition, flummoxed the roundtable, as well it should.
Plowing fearlessly on, the CFTC roundtable tackled the way markets are responding to changes thus far (whatever anyone thinks they might be). One roundtable participant made what I think is a critical point—if we don’t know what liquidity is, especially under current market conditions, then a simple way to judge it is whether folks can get their deals done without taking risks or paying costs they think unacceptable. In short, as I said, you know it when you see it.
A discussion of who’s making markets in which assets under what rules then made my head hurt, but it leads to the unavoidable conclusion that there are fewer liquid market participants willing or able to bet on fixed-income assets when the herd is running the other way. In short, fixed-income markets are increasingly procyclical and central counterparties and all the other clearinghouses meant to mediate these wild rides have yet to prove themselves.
Indeed, these hoped-for liquidity powerhouses may exacerbate risk because of pricing differences among these privately-owned market utilities, incentive misalignment, and incomplete rules—not the least of which deal with what to do if a clearinghouse stops clearing. As everyone at the roundtable readily acknowledged, this is way scary.
But, if the presentations about market risk were daunting, those from regulators were damning. Regulators deplored growing risk but—be afraid—said they could do little to address it. The CFTC is, they said, just one regulator among many, and none of the agencies agree on much of anything except that each has a jurisdiction it for sure won’t share.
Where does this leave all of us? To another exciting roundtable, no doubt, not to mention to lots more doctoral dissertations on market risk measurement, models, and mechanics. I’m a big fan of doctoral dissertations—I’ve got one myself to share should anyone be short a whopping paper to read—but none of these will guide policy-makers any better than the amassed insights of market experts at this roundtable were able to do.
Policy-makers at the session saw themselves as powerless to step in even as risks mount, but I wonder how hard any of them has truly tried. A clear signal about looming risk and desired remedies—preferably stripped of partisan rhetoric and retributive statements about the Obama Administration—would be a great, real first step to addressing market risk, especially given how imminent its threat appears to loom.