Mind the gap

Years ago bank traders treated FX markets with caution (particularly if they weren’t experienced currency dealers) indeed other areas of the bank were specifically prohibited from running FX positions. This wasn’t a turf war. It was sound risk management. There was always the fear that some unexpected event would leave you on the wrong side of a trade. Similarly unmatched borrowing in low interest rate currencies was not a recommended strategy. From time to time even the big boys dropped a ton. Evidence that this has been forgotten emerged recently when Swissy revalued. Punters took a hit often magnified by using margin (aka leverage). This prompts questions. Do “retail” customers understand the risks they face? How do brokers manage margins? Was there mis-selling? Like most things in markets there’s a lot of subjectivity. Is there anything we can learn? I think so. Central banks have created the mirage of a benign environment.  At the same time regulators have reduced the market’s capacity to act as a buffer. This increases the risk of a stampede to the exit when the door is locked and bolted. Under such conditions price adjustment is swift and discontinuous. As a consequence standard risk measures like VAR become useless. Even stress testing is limited in its efficacy. Based on plausible events the stresses themselves become influenced by a bias to short term experiences. Is there anything you can do? Apply a swift and extreme market move (much greater than a plausible stress event suggests), assume no trading and look at the result. Can you live with it? Nursing a big loss is one thing but does it bankrupt you? In other words mind the gap.