Understanding collateral runs

April 14, 2018

In normal financial runs lenders want their money back. In collateral runs borrowers want their collateral back. In today’s highly collateralized financial system the institutions at risk are broker-dealers that lend and borrow cash in secured transactions and that use part of that liquidity to fund their own asset holdings. In collateral runs cash borrowers, such as hedge funds, have an incentive to rush to repay secured loans as soon as the liquidity of a broker-dealer is being questioned. That is because haircuts keep collateral value above loan notional. The demise of Bear Sterns in 2008 illustrates that the peril of collateral runs is real. Still, this source of liquidity risk has not been well explored.

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How to prepare for the next systemic crisis

April 7, 2018

Systemic crises are rare. But they are make-or-break events for long-term performance and social relevance of investment managers. In systemic crises conventional investment strategies lose big. The rules of efficient positioning are turned upside down. Trends follow distressed flows away from best value and institutions abandon return optimization for the sake of preserving capital and liquidity. It is hard to predict systemic events, but through consistent research it is possible to improve judgment on systemic vulnerabilities. When crisis-like dynamics get underway this is crucial for liquidating early, following the right trends and avoiding trades in extreme illiquidity. Crisis opportunities favor the prepared, who has set up emergency protocols, a realistic calibration of tail risk and an active exchange of market risk information with other managers and institutions.

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The passive investment boom and its consequences

March 31, 2018

Passive investment vehicles have been expanding rapidly over the past 10 years, with assets reaching about USD8 trillion or 20% of aggregate investment funds last year. ETFs alone now account for 14% of fund assets. Beyond, the share of informal passive investing, such as ‘closet indexing’, is probably even larger. The plausible consequences of the passive investment boom include [i] less information efficiency of markets, [ii] greater incentive for low-quality issuance and corporate leverage, [iii] greater price correlation across securities, and [iv] stronger transmission of financial shocks into emerging economies.

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Modern financial system leverage

March 24, 2018

Leverage in modern financial systems arises from bank balance sheets and off-balance sheet transactions that involve banks and other financial institution. Non-bank funding of banks and credit is large, rising, and not fully captured in official statistics. Collateralized transactions and wealth management products are important underappreciated parts of system leverage. The classic narrow focus on bank credit-to-GDP ratios does not only underestimate leverage in size, but also overestimates the stability of sources of funding.

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Interest rate swap returns: empirical lessons

March 17, 2018

Interest rate swaps trade duration risk across developed and emerging markets. Since 2000 fixed rate receivers have posted positive returns in 26 of 27 markets. Returns have been positively correlated across virtually all countries, even though low yield swaps correlated negatively with global equities and high-yield swaps positively. IRS returns have posted fat tails in all markets, i.e. a greater proclivity to outliers than would be expected from a normal distribution. Active volatility management failed to contain extreme returns. Relative IRS positions across countries can be calibrated based on estimated relative standard deviations and allow setting up more country-specific trades. However, such relative IRS positions have even fatter tails and carry more directional risk. Regression-based hedging goes a long way in reducing directionality, even if risk correlations are circumstantial rather than structural.

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Identifying asset price bubbles

March 10, 2018

A new paper proposes a practical method for identifying asset price bubbles. First, one estimates deviations of prices from fundamentals based on three different approaches: a structural model, an econometric data-rich regression, and a purely statistical trend filter. Then one computes the first principal component of the three deviation series as an estimate for the common component behind them. As a general approach the method holds promise for detecting price distortions in financial markets and setback risk for ongoing trends.

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Directional predictability of daily equity returns

March 3, 2018

A new empirical paper provides evidence that the direction of daily equity returns in the Dow Jones has been predictable over the past 15 years, based on conventional short-term factors and out-of-sample selection and forecasting methods. Hit ratios have been 51-52%. The predictability has been statistically significant and consistent over time. Trading returns based on forecasting have been economically meaningful. Simple forecasting methods have outperformed more complex machine learning.

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The shadow of China’s banks

February 24, 2018

Unlike in the U.S., shadow banking in China is dominated by commercial banks, not securities markets. Regulated banks operate most shadow banking activity, take direct risks, provide implicit guarantees and use non-bank entities to shift assets off their balance sheets. That is why China’s shadow banking is called ‘the shadow of banks’ and why it is such a central factor of systemic risk in this highly leveraged economy. China’s shadow banking has important economic functions for individual savers and smaller enterprises. Outstanding ‘shadow savings’ are estimated at roughly 70% of GDP.

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The danger of volatility feedback loops

February 17, 2018

There is evidence that the financial system has adapted to low fixed income yields through an expansion of explicit and implicit short volatility strategies. These strategies earn steady premia but bear large volatility, “gamma” and correlation risks and include popular devices such as leveraged risk parity and share buybacks. The total size of explicit and implicit short-volatility strategies may have reached USD2000 billion and probably created two dangerous feedback loops. The first is a positive reinforcement between interest rates and volatility that will overshadow central banks’ attempts to normalize policy rates. The second is a positive reinforcement between measured volatility and the effective scale of short-volatility positions that has increased the risk of escalatory market volatility spirals.

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The systemic risk of highly indebted governments

February 10, 2018

The public debt ratio of the developed world has remained stuck at a 200-year record high, even with a mature global expansion and negative real interest rates. This poses a systemic threat to the global financial system for at least three reasons. First, governments’ capacity to stabilize financial and economic cycles is more limited than in past decades, which matters greatly in a highly leveraged world that has grown used to public backstops. Second, many countries have taken recourse to mild forms of “financial repression”, which puts pressure on the financial position of savers and related institutions, such as pension funds.  Third, future political changes in the direction of populist fiscal expansion can easily raise the spectres of old-fashioned inflationary monetization or even forms of debt restructuring.

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Macrosynergy is a London based macroeconomic research and technology company whose founders have developed and employed macro quantamental investment strategies in liquid, tradable asset classes, across many markets and for a variety of different factors to generate competitive, uncorrelated investment returns for institutional investors for two decades. Our quantitative-fundamental (quantamental) computing system tracks a broad range of real-time macroeconomic trends in developed and emerging countries, transforming them into macro systematic quantamental investment strategies. In June 2020 Macrosynergy and J.P. Morgan started a collaboration to scale the quantamental system and to popularize tradable economics across financial markets.

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