Market failure in action…

by George Hatjoullis

I have described market failure in some detail in earlier blogs but we may be seeing such an event unfold right now (4pm 11/12/2015). The early signs are highly volatile and somewhat perplexing price action. Why, for example, should copper rally and miners decline in price?

The key to market failure is counter-party risk. A fear of default seizes the markets and, since no one knows how the counter-party risk will evolve, all positions are closed. If you do not have a position you cannot experience a counter-party failure (unless you have an uninsured bank deposit and the bank fails). The price action reflects closing positions rather than an investment logic and the price moves will be counter to whatever was happening before.

Not all positions can be closed however or at least not all traders are willing to book the losses involved. In these circumstances a ‘hedge’ is sought. The only true hedge is to close the position but quasi-hedges are often conjured in the credit default swap market. One buys protection against default by a specific counter-party. Of course this is nonsense because all you have done is exchange one counter-party for another, namely the CDS counter-party. If the problem is not knowing how counter-party risk is distributed across the market, you may have achieved nothing. Once the impossibility of hedging counter-party risk is grasped real panic sets in and the market (s) fail.

The failure is ensured by the brilliant innovation of mark to market. A position must be valued at some point (usually the end of the day) at a recognised market price. The market prices may not unfortunately be ‘real’ in the sense that if you tried to close the position it would be at a  very different price if indeed you are able to close it at any price. If the end of day price is the result of a counter-party panic they will almost certainly not be meaningful. For those showing mark to market losses real actions may be required such as closing the position. But nobody wants to open a trade at that price or any other price because they are trying to cover all counter-party risk. They price to miss and the loss gets worse. A horrible spiral of loss-inducing prices ensues and the much feared defaults are caused. This increases the counter-party risk and intensifies the crises.

Things may not get too bad this time, but then, you never know. The source of the problem is fear of default among the extractive industries and commodity producing nations. However, there is not complete transparency as to where this debt sits or any leveraged positions based on this debt. So who knows…?