Continued from Part One on August 15

By Krzysztof Rojek, Senior Director of Global Solution Consulting, Finastra

High volatility and low liquidity in the treasury bond market, combined with hidden pockets of leverage, have created a recipe for a black swan event. We’ve already seen a glimpse of it in the UK with a massive sell off in gilts — long regarded as a risk-free asset — in September of 2022, followed by the Bank of England intervention to calm down the dysfunctional bond market. On the wildest day, 30Y gilt yields moved in a 1.3% range – first the self‑reinforcing “fire sale”, which was then followed by the intervention – including a move of 1% in less than 30 minutes.

Hidden pools of leverage could lie with other respectable institutions, like asset managers or insurance companies. They could involve OTC instruments or real estate or even the private credit market. Not so long ago we saw another example where lack of transparency led to catastrophic results, when family office Archegos Capital Management cost six large banks more than $10 billion (£7.9bn) by defaulting on margin calls in March of 2021.

Because family offices are subject to little direct regulatory scrutiny, Archegos was able to build a very significant equity market exposure using OTC derivatives — known as Total Return Swaps — that imitate stock investment without the need for a physical underlying stock transaction that would need to be reported.

We’re also yet to see the entire aftermath of the collapse of cryptocurrency exchange FTX, which itself could have been a consequence of another event in the crypto world. In May of 2022, the “safe” Stablecoin, LUNA, also collapsed, wiping out an estimated $60 billion.

While comparing G7 bonds to unregulated cryptocurrencies may seem like a stretch, let’s consider some facts before writing off the warning signs. First, consider that volatility in US Treasuries was higher than that of the notoriously high crypto markets for quite a few days in 2022. In mid-June 2022, for example, the benchmark 10-year US Treasury moved by more than four standard deviations, which is supposed to happen once in more than a century.

Second, the largest central banks in the world are raising interest rates at an unprecedented pace. Between  March 2022 and May 2023, the Federal Reserve Bank increased interest rates 11 times, while also withdrawing vast amounts of liquidity from the Treasury market at the same time. Worse yet, they may no longer be able to afford to cut rates when economic indicators turn south or financial markets show more signs of stress, as this would undermine their primary mandate to keep inflation in check. With this kind of uncertainty about the future path of interest rates, it’s no wonder that market commentators remarked that Treasuries were trading like crypto on several occasions in 2022.

Fast forward to 2023, and we’ve seen a number of bank runs in the regional banks space in the US, some of which succeeded. In March, financial regulators closed Silicon Valley Bank in a stunning mid-day move as the intraday deposit withdrawals projection pointed to the bank’s collapse. What caused the run initially was the need to sell the US government-backed bonds at the then prevailing market prices, forcing the bank to immediately realise losses on the Held-to Maturity (HTM) portfolio. An incomprehensible lack of Risk Management function at the bank, and the vastly accelerated speed of deposit withdrawals in a mobile banking era did not help SVB either, of course.

The decisive action by the US government and the regulators to accept those HTM bonds at their face value and provide the liquidity to the banks in a similar situation seemed like a great idea at the time. In fact, it was a brilliant win-win situation where neither the Fed nor the taxpayers need to pay anything, the banks do not have to realise their unrealised losses, and the depositors get peace of mind that their banks have liquidity situation back to where it was before the rate hike cycle started.

But it only worked until it didn’t. On April 24, First Republic bank delivered a dreadful earnings report and a bizarre 12-minute earnings call without Q&A. Its stock price lost half of its value the very next day and continued to fall until the Federal Deposit Insurance Corporation closed the bank and then sold it to JPMorgan Chase over the weekend. While this bank’s situation wasn’t as spectacularly bad as SVB, the fundamental reason for the precipitous stock price drop – from 115 on March 8 to the last trade at 3.5 on April 28 – was the same: their balance sheets were not prepared for the steep rise of interest rates.

Putting it all together creates an important warning for investors and banks in today’s interconnected financial markets: there are no “risk-free” assets anymore. Hidden pockets of leverage are unstable and easily detonated with an unknown charge, and central banks can no longer be relied on to douse the flames. In 1995 an earthquake in Kobe was the trigger that put the oldest merchant bank in the UK out of business due to the actions of one infamous derivatives trader.

Today, it may not even take a climate, geo‑political or pandemic related event to destabilise major financial markets. In fact, even the mere pain of higher funding costs may be the trigger, if the rates stay at current levels for longer than is expected. We have seen how customers move their money to higher yielding assets than bank’s deposits with SVB and First Republic, and we have not even touched here on Credit Suisse, whose chairman Axel Lehmann said that the SVB crisis looked contained and his bank had a strong balance sheet less than a week before his bank was taken over by UBS – but that’s a completely different story…Fasten your seat belt and prepare for more turbulence ahead.