Systemic Liquidity Risk and Bipolar Markets

Beschreibung

The dramatic and well chronicled crisis of 2007/8 marked awatershed moment for all stakeholders in global capital markets. Inthe aftermath, financial markets have become even more tightlycoupled as correlations in returns across multiple asset classeshave been at historically elevated levels. Investors and fundmanagers are, to a much larger degree than previously and oftenmuch more than they realize, subject to the risk of severe wealthdestruction. The ultimate hazard, which is not adequatelycharacterized by the widely touted notion of tail risk, is thesystemic risk which arises when liquidity in markets completelyevaporates. Not only did this happen in the second half of2008, but it has been repeated episodically since then - mostnotably in May 2010, in an incident known as the Flash Crash, andin the fall of 2011 when correlations were at historically elevatedlevels. Conventional asset allocation tools and techniques have failedto keep apace with the changing financial landscape which hasemerged since 2008. In addition to the preponderance of algorithmictrading and the associated changes in the liquidity characteristicsof financial markets, a new paradigm of risk on/risk offasset allocation has emerged. Risk on/risk off is a widelyadopted style of trading and macro allocation strategy wherepositions are taken in several closely aligned asset classesdepending on the prevailing sentiment or appetite for risk. The consequences of the day to day (and intraday) switching betweeneither a risk on or risk off tactical strategies poses significantnew challenges to investors who are still making investmentdecisions with outmoded notions from traditional asset allocationtheory. How can one cushion the impact of systemically threateningevents when the ability to exit financial instruments becomesalmost non existent? How can one trust the integrity of financialmodels and orthodox macro financial theory which have becomeincreasingly discredited? Can central bankers be relied upon tobecome the counter-parties of last resort and provide a safety netunder the financial system? These vital questions, and manyothers, need to be addressed by everyone who has a stake in modernfinancial markets, and they are addressed in Systemic LiquidityRisk and Bipolar Markets. Proper functioning markets require fractiousness or dividedopinion, and this needs to be lubricated by communications fromcentral bankers, economic forecasters, corporate executives and soon. As long as such messages and market conditions remainambiguous, providing asymmetric information to different marketplayers, then the conditions are present to enable systemicliquidity to be preserved. Seen in this context the prevailingparadigm of bipolar risk on/risk off asset allocations isboth a prerequisite to liquid markets, and also paradoxically, whenone side of the polarity becomes too extreme, a major source ofsystemic instability. Should such polarities becomecritically unbalanced, and should the signals received by marketplayers become symmetrically disadvantageous as they were in thefall of 2008, then an even more substantial systemic liquiditycrisis than that seen in those troubled times is a dangerouspossibility. Apart from the practical risk management tools and tactics thatare recommended in Systemic Liquidity Risk and BipolarMarkets, there is a provocative and cogent narrative to provideanxious and perplexed investors with a coherent explanation of thepost GFC financial environment, and which should assist them innavigating the choppy waters ahead.

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Clive M. Corcoran

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