Responding to Risk with Intelligent Analytics

By Joe Budden

Following the financial crisis of 2007-2008, many veteran traders were faced with a totally different financial landscape in which to operate. The ‘New Normal’, a term first coined by Pimco trader, Mohammed El-Erian, became the finance community’s go-to word for a new world order which bore more similarities with the post Depression era than anything investors had previously experienced.

This ‘New Normal’, characterised by persistently sluggish growth, high unemployment and political wranglings over debt ceilings and budget deficits, is now five years on and shows no sign of abating.
But it is not only political parties that stand to lose from this new period of economic stagnation.
Financial markets, as a result of huge injections of artificial liquidity from central banks, now reside atop a mountain of debt and are precariously placed should we see any reduction in liquidity or future drop in growth.

Indeed, it could be argued that the super loose monetary policy used in response to the biggest recession since the 1930’s has actually heightened risk, and the resultant artificial rally in global stock markets has created a world in which markets are now scarily dependent on the money flows from central banks.

Much like an addict becomes dependent upon a drug, the financial markets have become dependent on the monthly injections of quantitative easing from the Federal Reserve, and it is for this reason that every FOMC meeting is now watched with baited breath by most traders.
And just like the symptoms of withdrawal when such a drug is taken away, the potential for significant market volatility is profound and something that every investor and trader should be prepared for.

The next shock to the system: Inflation

At the heart of the problem financial markets face is a battle between stagnant economic growth and the coming onslaught of inflation, brought on by years of easy money. Normally this would not present too much of a problem since periods of economic stagnation can be easily prodded into life by central bank intervention.

However, to believe this is to forget that the central banks have now used up all of their bullets. Indeed, central banks now sit on a mountain of debt with no alternative but to scale back, or ‘taper’ as the Fed like to call it - rhetoric that has already caused significant turmoil in stock markets over the last couple of months.

And with the prospect of future unwinding, the already fragile growth picture seen in most developed nations, has the potential to stall even further. (Indeed, recessions typically occur every 4-6 years in developed countries meaning we are now overdue.)

Could the next crisis be worse than ‘08?

Such deficits need austerity, not additional debt, which is why when the next slowdown comes, as it surely will, the financial comedown is likely to be as severe if not worse than that of 2007-2008. Central banks cannot inject any more liquidity because the debt is too big, and they cannot cut interest rates because rates are already at zero.

You can see now why the propping up of huge, failed institutions is rarely conducive to a smooth running financial system.

Obviously, such heightened risk requires a requisite response that is tailored not only to protect capital but to take advantage of such risks and it is here that investors must seek out the tools that will enable them to survive during such a scenario. New regulations and compliance also mean that traders need to operate in a new, more tightly controlled environment.

Weathering the storm with intelligent analytics

The internet has brought with it many advantages, however, the world we live in is now faced with information overload and a rapidly changing business environment. For financial markets, this means new risks - long tail events, flash crashes - as well as new opportunities such as social trading.

More than anything though, traversing the new world with its glut of information, requires ever more sophisticated tools to analyse data, discover new metrics and respond to them in a timely manner.
Which is why in this changing environment, it is not enough to simply rely on the tools of yesteryear, no matter how successful they may have been.
For one thing, the ‘New Normal’ is not a world that anyone knows, and for another, new regulations mean that the trading environment requires more sophisticated and more controlled measures.

Indeed, in order to navigate the coming volatility, new analytics will become ever important;
Back-testing and stress-testing, systems developed with GIPS compliance in mind, forensic bond analysis and measures for liquidity risk as required by UCITS IV.

Such systems (and they are already coming into existence, i.e. StatPro Revolution) will be located in the cloud by necessity and will offer daily risk reports and up to date leverage analysis. This is technology that enables investors to adjust their portfolios systematically and to optimise risk based on their own metrics. Technology that will be the future of data processing across all industries, not just finance.

The next phase

However, just as information will need filtering, markets will need overseeing, and as the Fed begins to unwind it’s aggressive monetary policy, the ‘New Normal’ may well give way to a new type of order - a world where information is likely to be the next hot commodity. We may be already seeing this shift taking place.

Any technology that allows the efficient processing and analysing of such information will be worth more than its weight in gold.

Bio:
Joe specializes in writing for the finance industry and has written articles for numerous offline and online publications. He takes special interest in trading techniques, technical analysis and the psychology of trading.