Some wise words that offer guidance on the vectors of a future debt crisis…
WHEN, NOT IF
My LinkedIn feed was filled last week with posts about the 10yr anniversary of the Lehman collapse, and I found it odd the sort of romantic sentimentality people ascribed to the event. Frankly, it was one of the darker times in recent economic history, and its effects have rippled out into our larger society in ways we have yet to fully understand. We love to bash Millennials, for example, but fail to acknowledge that their prospects for financial prosperity were greatly hindered by the greed and arrogance of prior generations. Or, a rise in Nationalism always follows an economic meltdown, and that affects how the next crisis develops. The circle is never complete.
The truth is: despite the decade-long bull market, we didn’t overcome the crisis we merely postponed it. There are financial truths that have yet to bear fruit, and it’s not a question of if, but when. Each crisis holds certain patterns that make it similar to the last, but how we deal with the next crisis will be shaped by technology more than any time in history.
When the next financial crisis hits, FinTech will shape how it is predicted, how it is executed, and how the market moves in response to each piece of negative news. The Great Recession that started in 2007 was largely the result of synthetic derivative instruments that exposed banks and funds to risks they did not fully understand until it was too late. In the same vein, there are seemingly minor FinTech advancements that will shape the response to newer crises in ways we need to understand before going back down the rabbit hole. So, on that happy note, let’s try and get ahead of the game and imagine some of those effects...
As I entered University in 1992, I thought I needed to study economics and finance in order to be a market trader. I should have majored in psychology. When a crisis hits, the markets are powered by the human emotions of greed and fear rather than financial logic. Yes, the fundamentals of finance will come home to roost at some point, but that may take decades. In the words of the great John Maynard Keynes, the market can remain irrational longer than you can remain solvent. As a trader, if you get “the tap” from your boss on a Friday afternoon to cut risk, you couldn’t give a damn about fundamentals.
Algorithmic trading is in its infancy in fixed income, less so in equities. That said, most dealers worth their salt have some form of algorithmic pricing when it comes to flow product. There are bands of pricing for differing clients, normally in retail sizes. Couple that with a rise in developmental AI trading firms, and we start to strip out human emotion to some degree. Yes, the base price upon which the algo derives its price is still controlled by human input, but the reaction to that price move is less analog.
Funds, meanwhile, love to tout the move to ETFs and passive investment as "the future." The money invested in passive funds has stripped human emotion from a portion of traded credit. That's hugely important when it comes to market shifts and panic as it changes the dynamic of certain market flows. Right now, the margins are so tight that a real live human has little ability to generate meaningful Alpha, but what happens when an IG bond drops five points in a morning trading session? Bond ETF’s have grown in popularity in one of the tightest rate markets in economic history. Europe is running negative yields as a common occurrence. Almost none of these credit funds and the systems behind them are tested in a crisis, and there aren’t simulations that can be run because every crisis has nuance. That’s the whole point of debt crises – they come from places the greater market failed to predict with any accuracy.
So, with funds operating crisis-untested ETFs, and dealers increasingly pricing using algos, we expose the debt markets to two new factors: 1) unpredictable equity-style “flash crashes,” and 2) limitations on human emotion when it comes to (largely retail) pricing decisions.
We all know damned well what happens next: we turn off the bots as they start to lose money. Just as a pilot would grab the controls if autopilot started to fail and the plane started to nosedive, we would see algo pricing shut off as bond markets started to puke. It’s not quite that easy with the ETF and passive funds, however, and that’s worrying.
Investors get scared of automated or linked investment without human input when markets collapse, and even if the bots are better at extracting value than humans they will demand a human touch. As an investment society, we aren’t there yet when it comes to trust in the algorithms. Think of it like autonomous automobiles: statistics suggest Tesla cars crash at a dramatically lower rate than human drivers, but the majority of the population would still refuse to allow their Model X to drive their kids to school. It's the same with ETF's - they may be better at diversifying longer-term exposures to the market in a tight rate environment, but investors will get twitchy when they read their loss statements and insist the humans take the wheel. How those ETF's have affected the broader market in the meantime is yet to be seen, and these ETF's still function in a market dominated by human emotion.
DATA AS CANARY
When I traded European Bank CDS names in early 2007, the ABS trader kept walking over and casually buying single name protection in HBOS, Northern Rock, and the Irish banks. At the time, he seemed like a fool as CDO’s had compressed spreads to single digits in these names. But he was seeing fundamentals in his market turn ugly, and was buying protection “just in case.” His market was the canary in the coal mine. We ended up asking to sit next to one another because our markets were inextricably linked even though my market was ignoring his entirely.
In fixed income, data analytics are still in their infancy, but they are vastly superior to where they were a decade ago. Large dealers and funds are able to strip out and properly analyse data streams they couldn’t access before. Consider the large US dealers who sit on data such as auto loan delinquency rates, regional home values, average loan changes, credit card debt statistics… it’s overwhelming. All of these data points are lead indicators to market shifts, and FinTech has made it so much easier to evaluate causality. Theoretically, the canaries in the coal mine should be easier to spot this time around, and the market participants should be able to adjust more gradually than before to impending crisis. The only problem: human greed has a tendency to ignore red flags until they become too obvious.
ACCESS TO CREDIT
By definition, a credit crisis is a squeeze on the ability to borrow money. It becomes impossible for anyone to fund themselves at reasonable spreads. Now, the cheap money that has flooded the market since 2007 has meant that any corporate treasurer with a pulse has borrowed for their needs as much as possible. But there are of course EM treasurers that have borrowed in dollars, and countries like Turkey that test this ability to borrow even at the best of times. The crisis will hit all of them hard, and then it will leak into the rest of the market.
However, FinTech is going to change access to funds for many corporates in subtle ways. There is a huge push at the moment for FinTech-enabled funding systems that circumvent the banks and work direct from investor-to-corporate treasurer. This creates a hugely important new access channel on smaller, privately placed deals with reduced fees. In the midst of a crisis, the funds still have money to invest on an individual basis, but the markets cannot absorb deals of any decent size.
By granting corporate treasurers access to smaller bespoke deals with individual investment funds on a need basis, FinTech will release some of the credit squeeze pressure. Think of it like this: an individual person may not be able to secure a $50k bank loan without a job, but can secure smaller P2P loans from friends that help cover rent for a few months longer until they reach gainful employment. FinTech is recreating that scenario in larger scale. It's still a drop in the ocean (for now), but the ramifications of this FinTech segment's growth are enormous.