At a credit control meeting some time ago I asked if we really understood the risks we ran. The response was positive and then came Lehman and the market crisis of 2007-2008. Asking the same question is even more difficult today. Have we a grip on the political risks that face investors with global economic warfare having become a reality? Is the daily dose of new regulation, adding to the gargantuan pile of historic, protecting us or creating the ideal environment for regulators to spread liability across surviving market players in the event of a major failure? Do we really understand those ever more complex funds’ hedging strategies? And what will we do about crypto custody, crypto currencies and the conflicting worlds of the regulated banker and the anarchic ideals of the founders of the crypto world?
Political risk is a tricky issue. At first glance it is not an issue for the post-trade sector, for it is an investment consideration. But the nature of political risk has changed. It used to be country-centric. When the Russia-Ukraine conflict started, the issue was very country-specific. Soon it extended into financial warfare with account freezes and payment restrictions. Now it has moved into commodity price management in gas and electricity. Potentially it could move into other critical areas, not only commodity based but also manufactured. Its impact could be impacted by the legal structure of a fund or its managers, administrators or depositary. Despite all the careful escape clauses around compliance with government directives in our documentation, we need to be cognisant of the legal status of any action or fund structure that could adversely impact a fund or its investors. At a minimum we should draw up a schedule of the political touch points for each fund or fund group.
If I look back over my years in the market, one of the critical barriers that were breached was, with AIFMD, the liability accepted for wider risks of loss of assets. In the last decade of the last millennium, that issue was closely debated in the USA and senior figures in the industry came to the sensible conclusion that the depositary, or its legal equivalent in other structures, was not the unlimited guarantor for asset safety. But those many decades ago, regulation was simple and, to some extent, principle-based. Then the lawyers came in in force! Now it needs definition down to the last miniscule detail.
Compliance manuals look more like operating procedures, except that they are obviously written with an eye on the Courts as much as on successful completion of a transaction life cycle. In reality, they are a time bomb waiting to explode and I remain amazed at some players’ quite cavalier acceptance of risks, especially around leverage, liquidity and line of sight over assets, in these complex markets
Although all can appreciate the value of simple hedges such as currency overlays and it is not the job of custodians and their ilk to challenge such practice on investment grounds, many strategies are highly complex with bespoke structures and unique documentation. As new instruments are added to the hedging armoury, few can keep up with their complexities or gauge the hidden risks behind such innovative finance. The key question is what constitutes due diligence when faced with such issues and what is the role of the depositary as guardian of the assets? I suspect that both will be answered only once the risk – and potential losses – have crystallised. Ignorance though is likely to be seen as a weak defence! And that will lead to a replay of the legal challenges we saw in the post-Lehman era when depositary liability was redefined.
I am enthusiastic about crypto and have seen amazing use of blockchain, its technological mentor. But there are many crypto investments ranging from offerings with the value of the Tulip Bulbs of Amsterdam in the 1630’s to solid offerings in modern day CBDC form. And we are all eager to act as custodian or its ethereal equivalent, or find other ways to add value, to these new instruments. We have seen implosions in this market simply due to a blind disregard to some basic rules of finance. Collateral is part of this deception for many assumed that collateral did not need explaining; they ignored the fact that a dollar of collateral in a bull market does not mean a dollar of collateral when the bears take charge. Collateral has to be transparent – not down to the specific instrument but at least by categories. Its ownership has to be legally robust. Collateral liquidity and values have to be managed and a policy is vital at each collateral location for illiquidity and price erosion. And the more collateral held in each pot, and the more volatile the structures it relates to, the more conservative an approach is needed.
We have to recognise that an algorithm is most likely an inappropriate form of collateral. Solution of these issues is vital for exchanges and custodians as well as investors. For the failings and extreme volatility of the crypto space this year
is damaging to its longer-term viability. Crypto must have tangible value and not be a game of supply and demand in artificial pools of no intrinsic value.
The challenge for the market is to co-manage these event risks alongside the traditional risk profile of the industry. Political risk, regulatory overload, hedging strategies and cyber are not unknown challenges, but are they really understood and how should we manage them? Ignoring them is not the answer!