RISK MITIGATION: LIQUIDITY, CUSTODIAL & COUNTER PARTY RISK

As the markets have exploded into the new world of passive investing via ETFs and Robo-Advisors, few fully comprehend the new stealth areas of risk.  Risk Mitigation plans in the areas of Liquidity, Custodial and Counter Party Risk may currently be central to your financial survival if a new crisis were to suddenly occur.

We have consistently witnessed that when a real or perceived crisis arrives; markets freeze, trading is halted and even ATM's are often quickly locked down. What happens to your digitally represented wealth while you are locked out watching cascading events unfold?  Are you safe or at the whim of how your financial matters will be sorted out by regulators  and the courts, charged with sorting out the mess. Today this is a very real looming risk!

CUSTODIAL RISK

A custodian is a financial institution that holds customers' securities for safekeeping to minimize the risk of their theft or loss. A custodian holds securities and other assets in electronic or physical form.  THESE ARE BUSINESSES: In addition to holding securities for safekeeping, most custodians also offer other services, such as account administration, transaction settlements, collection of dividends and interest payments, tax support, and foreign exchange. The fees charged by custodians vary, depending on the services that the client desires. Many firms charge quarterly custody fees that are based on the aggregate value of the holdings.

COUNTER PARTY RISK

Counterparty risk is the risk to each party of a contract that the counterparty will not live up to its contractual obligations. Counterparty risk is a risk to both parties and should be considered when evaluating a contract. In most financial contracts, counterparty risk is also known as default risk. DO YOU REALLY KNOW WHAT COUNTER PARTY RISK YOUR PORTFOLIO FIDUCIARY HOLDS ON YOUR BEHALF?

LIQUIDITY RISK

I have interviewed Axel Merk a number of times and have found him to be quite insightful. I extracted the following from a recent article he wrote about "What Could Possibly Go Wrong?" which I felt raised important concerns regarding specifically Liquidity. We explore all areas in the THEMES section of the MATASII.com site.

Some things are different.

 The investment industry has evolved to provide ever more index products, with lots of touting how active management is dead. If that were true, we wouldn’t have a plethora of index funds for many slices of the market as selecting anything but a market portfolio is the very definition of active management. Then again, when “everything” goes up, does it really matter what you buy, so long as investors buy something? So what is different?

  • A new breed of liquidity providers

In the old days, we had banks and floor traders provide liquidity. Dodd Frank has significantly cut back the type of trading banks may engage in. And floor traders have been replaced by computers. Floor traders on the New York Stock Exchange used to have a duty to make orderly markets with the ability to slow down trading to match buyers and sellers. That philosophy lost out to the philosophy that speed is more important than price, meaning that if an investor wants to trade, let them trade instantaneously, even if the price needs to adjust sharply.

Today’s liquidity providers include ETF market makers and hedge funds. They will provide all the liquidity in the world, so long as everything appears orderly. But let the algorithms flag an abnormality, and their systems may go offline. Without going into the arcane details how market making works, let’s take a common model (there are others) how ETFs trade:

- A so-called lead market maker gets incentivized to offer a tight spread for an ETF (the incentive comes from the exchange giving the market maker a rebate on the price, i.e. giving them a price advantage through actual cash; the rebate comes from the exchange fee investors are paying).

- There’s a plethora of other market makers also providing liquidity, enabling what appear to be mostly efficient markets. These other market makers also get incentives from the exchange, albeit lower ones than the lead market maker. As a result, it creates a structure where all market makers can offload their risk to the lead market maker. This makes it comparatively easy for market makers to make markets in thousands of ETFs, as they don’t need to understand too well the ETF they are providing liquidity for; all they need to know is that they can offload their risk to the lead market maker.

- This system works great until the lead market maker has a glitch and takes its systems offline. When that happens, other market makers see that the party that is supposed to be best informed (the lead market maker) is stepping away. Not surprisingly, everyone else also steps away, causing spreads to widen.

- A flash crash can then happen if investors place large market orders just as liquidity providers are offline.

  • Lower volatility?

Markets have been rising on the backdrop of low liquidity. Why has volatility been so low? We see two primary drivers: the rise of machines, as well as central banks:

- To the extent that information is processed correctly, trading firms focused on ‘big data’ scanning the news flow automatically may well speed up how readily new information is absorbed in the market. As such, the rising influence of machines in the market may well contribute to the lower volatility we have seen. That said, we wonder how big that impact is.

- When ECB chief Draghi said, he’ll do “whatever it takes” to save the euro a few years ago, he put into plain English what had been happening for some time since the onset of the financial crisis: taking risk out of markets. A few weeks ago, he said in a press conference there’s no need to be concerned about upcoming events in the Eurozone because we can’t do anything about the outcome anyway; and if something bad were to develop for the markets, the ECB would take the appropriate action. Differently said: heads, I win; tails, you lose.

- More abstractly speaking, central banks have compressed risk premia through quantitative easing and their forward guidance.