Thursday, January 18, 2007

The Systemic Risk of Cross-Asset Everything

2006 was a year when cross-asset trading and risk really started to get a lot of press, including this post on cross-asset algo trading from Chris. Particularly interesting to the buy-side was the potential for increased leverage they would get from cross-asset margining and netting.

The thing that sticks out most in my mind though is something that Timothy Geithner, the CEO of the NY Fed said in a September 2006 presentation in Hong Kong. In this presentation he highlights the relationship between leverage and liquidity.

Let me give two examples of evolving market practices that may help alleviate one concern only to exacerbate another. Collateral plays an increasingly important role in counterparty credit risk management, particularly for highly leveraged counterparties. The increased importance of variation margining plays a critical role in counterparty credit risk management. These changes help limit the exposure of the core financial institution to losses among their leveraged counterparties, but they also act to exacerbate volatility, with asset price declines forcing further margin calls, adding for further market declines. Where initial margin is thin in relation to potential exposure, counterparties are more exposed to adverse movements in asset prices, and in a situation of stress the actions they take to reduce their exposure to further losses are likely to have a greater negative impact on market dynamics. In market conditions where initial margin may be low relative to potential future exposure, the self-preserving behavior of leveraged funds and their counterparties may be more likely to exacerbate rather than mitigate an unexpected deterioration in asset prices and market liquidity. As financial firms demand more collateral, funds are forced to liquidate positions, adding to volatility and pushing down asset prices, leading to more margin calls and efforts by the major firms to reduce their exposure to future losses. In the context of the previous discussion of externalities, firms’ incentives to minimize their own exposure can amplify the initial shock and impose on others the negative externality of a broader disruption to market liquidity.