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Monday November 20, 2006 - 10:05:18 GMT
Black Swan Capital - www.blackswantrading.com

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Should this worry us?

Key News

· ``It's been brutal,'' said Jeremy O'Friel, principal at Appleton Capital Management in New York, whose $150 million currency fund is down 11.7 percent this year. ``In the absence of volatility, it's very difficult to make money.'' (Bloomberg)

· Key Reports:

10:00a.m. Oct Conference Board Leading Indicators. Previous: +0.1%.



Quotable





“Our minds are designed to retain, for efficient storage, past information that fits into a compressed narrative. This distortion, called the hindsight bias, prevents us from adequately learning from the past.”



Nassim Taleb, Fooled by Randomness



FX Trading – Should this worry us?



We haven’t been worry warts to date on the growing level of derivatives in the system—probably for these reasons:



1) We don’t quite understand the rocket science behind them

2) We think the debt revolution that has allowed the consumer to manage his balance sheet in a way business has done for years is a good thing

3) If it weren’t for credit being doled out, our little business might never have seen the light of day



But, we can’t help but find the explosion of growth in the derivatives market eye-opening at the very least. This comes to us via Serhan Cevik, a Morgan Stanley economist, from his recent piece, The Curse of Alpha (our emphasis);



“The explosive growth in leveraged financial transactions is a potential threat to stability. Driven by the global liquidity cycle and investors’ growing risk appetite, the notional amount of exchange-traded derivative instruments increased from US$2.3 trillion in 1990 to US$14.3 trillion in 2000 and then soared to US$84 trillion in the first half of this year. According to the Bank for International Settlements, annual turnover recorded an astounding surge from 510 million contracts to almost 7 billion contracts over the same period. However, this is still just a small part of the pool of synthetically created financial products, most of which are actually traded over the counter. Indeed, the data compiled by the International Swaps and Derivatives Association show that the outstanding volume of over-the-counter credit derivatives increased from US$3.5 trillion in 1990 to US$63 trillion in 2000 and over US$283 trillion this year. Put differently, the total amount of exchange-traded and over-the-counter structured financial instruments ballooned from 27.3% of global GDP in 1990 to 772.8% this year.



Highly leveraged positions have started turning into a futile game of musical chairs. In today’s global network of financial markets, almost everything becomes interdependent and correlated, diminishing the advantage of portfolio diversification. Take, for example, the breathtaking rise of the hedge fund industry. In 1990, there were only 300 hedge funds in business, increasing to 3,000 by the end of the decade. On the latest count, however, the number of hedge funds reached over 10,000, with approximately US$1.5 trillion worth of assets under management. Although that may still look small relative to the rest of the investment community, hedge funds employing risky derivatives strategies to enhance returns already account for 45% of emerging-market bond trading volume and 55% of all credit derivatives trading in the world. In other words, the rise of hedge funds, driven by cheap financing, is behind the explosive growth in structured products and massive flows to emerging markets. However, as the number of players searching for arbitrage opportunities has kept increasing, seeking alpha via highly leveraged positions has started turning into a futile game of musical chairs. Indeed, as competition has squeezed returns, the number of failed hedge funds increased from 4.7% of the funds in operation in 2004 to 11.4% last year.



Yikes! The thought of thousands of hedge funds running for the exits at any one time is a bit disconcerting. And as we found out recently from the demise of hedge fund operator Amaranth, internal risk controls at these places isn’t always what it’s cracked-up to be.



“…hedge funds employing risky derivatives strategies to enhance returns already account for 45% of emerging-market bond trading volume.” This stat adds some weight to our ongoing view that the US dollar could see some major money flow on the risk-reduction trade—despite the warts within the US economy. This game of “musical chairs” stretching for yield into emerging market bonds, and other places emerging, might have something to do with the yen carry trade.



Is it an accident waiting to happen or are derivatives a lot more solid than the average mind can comprehend? Maybe if falling global liquidity begins to bite and a semblance of volatility returns, we might gain some further insight.





Jack Crooks, Black Swan Capital

 

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Forex news reports can be found on the forex research headlines page below. Here you will find real-time forex market news reports provided by respected contributors of currency trading information. Daily forex market news, weekly forex research and monthly forex news features can be found here.

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Real-time forex market news reports and features providing other currency trading information can be accessed by clicking on any of the headlines below. At the top of the forex blog page you will find the latest forex trading information. Scroll down the page if you are looking for less recent currency trading information. Scroll to the bottom of fx blog headlines and click on the link for past reports on forex. Currency world news reports from previous years can be found on the left sidebar under "FX Archives."



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