Trésorier/Treasurer magazine - N°89 - April/May/June 2015 - (Page 59)

The Risk Observatory by Hugues Pirotte (FinMetrics) Hugues Pirotte [Report] "Show me the money" There are many ways to lever up an activity: (1) debt allows you to boost your assets to invest, as long as you can reimburse it, (2) you might hide or transform risk exposures by using financial deriva- tives, as long as a no bigger-than-expected shock happens, (3) you can create a fake market, as long as we don't ask you to show the money before you collect enough benefits. What we know is that those activities require a liquid environment to subsist. Great liquidity allows to suffer longer drawdowns and bigger surprises. And the more you resist, the more confident the market gets about your so-called performance, which ultimately allows you drive more liquidity towards you. Some of the biggest scandals about those activities arose after periods of "easy" liquidity. As Warren Buffet puts it: "It's only when the tide goes out that you learn who's been swimming naked". Nick Leeson was able to make Baring's management think that his margin problems were just a temporary issue. Selling deeply out-of-the-money puts to cover the purchase of at-the-money calls allows you to be perceived as the best trader ever, as long as the first years are not too hard with you and no one will directly see the underlying snowball danger. Madoff used his prior reputation to avoid telling the truth for many years. Some sceptical fund managers had started to accept investing in his funds after some decades of seemingly good track records. Without judging anyone here, in conclusion, gaining time before having to show the money is the real underlying game. How do you gain time? Thanks to cheap liquidity and risk transformation. A good analogy can be found in the expensive transfers of sport players within the top leagues of some sports. We are always impressed by some millionaire transfers. If two teams trade a player at EUR 20 million with each other, no one has ever shown any money. Still, we would conclude that the new market value of those players is 20 million. In practice, those reciprocities are made less visible by the chaining of operations between a series of clubs. In some sports, this has made the top league very impermeable to newcomers. Paradoxically, elite clubs are encouraged to increase the transfer price of players since it raises the barrier to entry without impacting the current members. Some clubs have faced default when they were finally not able once to match the game and had to show the money. In finance, repurchase agreements have been mentioned several times as a good example of the lure (See Gary Gorton's article: "Slapped in the face by the invisible hand"*). The article of The Economist: "Neither liquid nor solid" in June 2014* shows a market of $1.6 trillion a day, but also a surge in failures to deliver the asset, up to a level close to $200 billion. Show me the asset. LE MAGAZINE DU TRESORIER / TREASURER MAGAZINE - N°89 - APR Together with some co-authors, we published a scientific report in Nature, in 2013, where we show that the resilience of the financial system in its capacity to absorb shocks and not propagating them beyond "the first circle" depends on the way the network is shaped, but also on the level of liquidity you inject into the system. Lack of liquidity increases substantially the propensity of contagion. It was a nice finding for the physicists and engineers of our team but it sounded obvious for the financial members. Still, liquidity is a phenomenon hard to master. Many studies and experts tend to look at liquidity only as an input into the system: a quantity and for the best ones, also the capacity to circulate. But liquidity is also an endogenous phenomenon, i.e. it results from the environmental conditions. Fear of investors can drain it very quickly and too much homogeneity in the way market participants react can lead to systemic risk. On the contrary, supreme confidence allows unhealthy situation to continue. / MAY / JUN 2015 The liquidity conundrum 59

Table des matières de la publication Trésorier/Treasurer magazine - N°89 - April/May/June 2015

Table of contents
Treasurers' kitchen nightmare
FATCA the next hassle for corporate treasurers?
Treasury is becoming much more...
One year on - EMIRage or EMIRate?
Making the most of trade reporting data
EMIR, where do we stand?
Surety bonds - gaining acceptance globally as performance security
The colour of money
Money Market Funds - adapting to a challenging landscape
Comment offrir un meilleur rendement monétaire dans un univers de taux bas?
A repolution - The new Repurchase Conditions
Finding a technology partner in a world of change
Raising your Cyber Security level with Cyber Threat Intelligence

Trésorier/Treasurer magazine - N°89 - April/May/June 2015