Trésorier/Treasurer magazine - N°89 - April/May/June 2015 - (Page 59)
by Hugues Pirotte (FinMetrics)
"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
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
Table des matières de la publication Trésorier/Treasurer magazine - N°89 - April/May/June 2015
Table of contents
FINANCIAL HIGHLIGHTS Luxembourg Tax News
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
15 MINUTES AVEC CBTI
THE RISK OBSERVATORY
LIFE BEYOND NUMBERS
Trésorier/Treasurer magazine - N°89 - April/May/June 2015