The Economist - USA (2022-02-12)

TheEconomistFebruary12th 2022 Finance&economics 63

marketbonds.Thesedynamicscontribut­
edtothepressureonliquidityintheTrea­
surymarketsinMarch2020.
Finally,thinkaboutthesettlementlay­
ers.Inthepast,banksoftensettledcom­
plextradeslikederivativecontractsorin­
terest­rateswapsbilaterally.Butduringthe
financialcrisisthismeantthattheycould
only seethe tradestheyhad witheach
bank,notthefullpicture.Eachhadnoidea
whetherthereweremitigating(orexacer­
bating)trades withothers. Fearful their
counterparts were insolvent, banks
stoppedlendingtoeachother.
Internationalregulatorsdecidedtotry
tofixtheseissuesbyforcingmorederiva­
tives trading through central clearing
houses,whichsettletradesbetweena wide
rangeofmembers.Positionsaretranspar­
entandnettedoff.Tojoina clearinghouse
a membermustpostan“initialmargin”in
caseitdefaultsonitstrades,andthatmar­
gincanclimbifmarketsmoveagainstit.
Therearenowa handfulofmajorclearing
housesworldwideincludinglchinLon­
don, which clears most interest­rate
swaps;iceinAtlanta,whichsettlescredit
defaultswaps;andthedtccinNewYork,
whichclearsandsettlesAmericanshares.
Insumthesechangeshavereducedthe
roleofbanks:theyownandintermediate
lessthaneverbefore,whilesettlementis
now carried out by centralised institu­
tions.Inmanywaysthisseemslikeanim­
provementovertheoldsystem,inwhich
banks whose failure could rock entire
economieswerehighlyleveragedandex­
posed to swings in asset values. But it
comeswithitsownpotentialperils.
Oneriskisthatalthoughleveragehas
falleninbanks,ithasgrowninsomenon­
banks,frominsurers to hedge funds.A
starkillustrationofthiswastheblow­upof
ArchegosCapitalManagement,a previous­
lylow­profilefamilyoffice,inMarch2021.
Thecasealsoshowedthatbankscanre­
maindangerouslyexposedevenwhenitis
non­bankstakingthecraziestrisks.Arche­
gos’scollapsecausedbanks—mostlythose
thathadserveditasprimebrokers—more

than$10bnoflosses.

Howmightthishigh­tech,bank­light

financialsystemfareunderseverestress?

Someinsightcan bedrawnfromrecent

mishaps.In2019,astheFedcutitshold­

ingsofTreasurybonds,interestratesinthe

overnightrepurchasemarket,wherebanks

and investorsswap Treasuriesfor cash,

spikedashighas10%.InMarch 2020 the

Treasurymarketwentintospasmswhena

floodofsellers,spookedbyilliquidityelse­

whereanddesperateforcash,alltriedto

offload bonds at once. Market­watchers

like Mohamed El­Erian, chief economic

adviser atAllianz, aninsurer,think the

short­squeezeinGameStopwipedasmuch

as5%offthes&p 500 ashedgefundswith

openshortpositionswereforcedtodelev­

eragetheirportfolios.

InthefirsttwocasestheFedultimately

savedthedaybybuyingassetsandcreating

liquidity. DuringtheGameStopsagathe

clearingsystemimposedsuchhighcapital

callsonRobinhoodandotherbrokerages

thattheywereforcedtosuspendtrading,

haltingthesqueeze.Hadit beenallowedto

continueitcouldconceivablyhavebank­

ruptedenoughfunds,andcausedthemto

fail todeliver enoughGameStopshares,

thattheretailbrokerageswouldhavebeen

forcedtobuytherequiredsharesatany

price.Thatcouldhavecausedthemtogo

bust,too.

Itispossibletoimaginesuchanevent

causinghavoc.Insteadofretailtradersand

otherinvestorsbuyingthedip,ashasbeen

their habit, markets continue to slide.

Movesarebigandwildbecausemarket­

makingcapacityisreduced.Margincalls

goouttoa slewofhedgefunds,someof

whichfailtomeetthembecausetheyare

moreleveragedthananyoneanticipated.

Bondandequityfundssufferoverwhelm­

ingoutflows.Tomeetredemptions,man­

agers sell their most liquid assets, like

Treasuries or blue­chip stocks, causing

yieldstojumpandequitiestofallfurther.

Retailinvestorsusetheirbrokerageappsto

baleoutoftheirinvestments,too.

Evenifthisdoesnottroublethebanks

much,suchaneventcouldupsetthewider

economy.“Ownershiphaswidenedsignif­

icantly,”saysMrEl­Erian.“Thatisa good

thinglong­term,butintheshorttermit

mightamplifyhouseholdfinancialinsecu­

rity.Peoplewithlessincomeandlessofa

wealthbuffernowhavea greaterpropor­

tionofwealthsubjecttovolatility.”

Insomewaysthiswouldmarka return

toform.Inthe1990speoplewouldgoout

shoppingonthebackofwigglesintheNas­

daq, because they felt suddenly richer.

Thatconnectionseemstohavereturned,

especiallyformovesincryptocurrencies

andpopularstocks.

In extremis, volatile markets could

promptbankruptciesofenoughleveraged

investorsorfundstowipeouta memberof

a clearinghouse—perhapsa smaller,weak­

erbankorinsurancefund—whichmight

inturnwipeouttheclearinghouse’sde­

faultfund.Thiswouldsendmargincalls

aroundallofthebanks.Ifthey,weakened

bythesamedefaultsthatfelledtheother

member,failedtomeetthese,theclearing

house itself could be jeopardised. Paul

Tucker,aformerdeputygovernorofthe

BankofEngland,haswrittenthata clear­

inghousethatcouldnotwithstanda mem­

ber’sdefaultcouldbea “devastatingmech­

anismfortransmittingdistressacrossthe

financialsystem”.

Bothpedalsatonce

This scenario is speculative fiction. At

somepointcentralbankerswouldstepin.

Theadvantageofmarket­basedfinanceis

thatinterveningbybuyingassetsisoften

enoughtoquelldysfunction.Butit ishard­

erforcentralbankerstointerveneiftheir

financial­stabilityobjectivesandinflation

mandatesarepullingthemindifferentdi­

rections,astheywouldbeatpresentwith

inflationwell abovetarget in many ad­

vancedeconomies.“You’dbesortofstep­

pingonthebrakewhiletryingtokeepone

footontheaccelerator,”saysSirJon.“It’s

notimpossiblebutit couldbedifficult.”

Thebigvulnerabilityofthenewfinan­

cialsystemisthatchaoscanbeself­fulfill­

ing:moreparticipantsareexposedtomar­

ketswings,andthoseswingshavebecome

potentiallymoreviolent.Thebanksthem­

selvesarecertainlymuchmoreresilient

thantheywerebeforetheglobalfinancial

crisis.Yetitisdifficulttoknowwhether

thehigh­tech,market­basedfinancialsys­

temthathasbeencreatedissturdierthan

themore bank­basedsystemof 15 years

ago.Thosestillinfortheridemaynothave

towaitlongtofindout.n

Stopthiscorrection,I wanttogetoff

Paper gains

United States, household net worth as % of GDP

Source: Federal Reserve

3

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