What is the price of oil telling you?
Recent events have given support to the market maxim that in a crisis, the only thing that goes up is correlation. But every crisis is different, and something new comes about. Perhaps the most lurid moves so far in the coronavirus aftermath have been in the oil price, with US crude oil dropping into negative territory for the first time in history before recovering to a nonetheless low level.
Oil underpins around 10 of the world’s top 50 corporations. It is probably the commodity most related to economic activity, showing the knock-on effect of the price wipe-out that has resulted from the coronavirus-driven drop in demand. NYSE “circuit breakers” were triggered three times by mid-March 2020, something that didn’t even happen once during 9/11.
And right now, the stage is set for these swings to drive volatility further.
The regulatory approach toward risk-taking for banks post-2008 prevents many large market players from leveraging short-term moves acting as a principal, where they would be able to dampen sharp price moves.
Negative oil prices might have been less negative, or even not negative at all, if most banks had not pulled out of the commodities markets.
Removing the ability of market makers in the middle to cushion the impacts of violent market moves has been one of the unintended consequences of regulation designed to protect banking from systemic risk.
This unintended consequence of the new regulations simply supports the famous Rumsfeld statement that,” It is not what you don’t know that hurts you, it’s what you don’t know you don’t know.”
So, while volatility is a fact of life, how can you continue to thrive in the face of it? Here are five ways to manage risk when running trading books in a crisis, based on my experience during these turbulent times.
- Never say never. No position is ever benign in a crisis.
- Know what you have in the books. Having a robust risk system is paramount; but knowing the pitfalls of the models is key. Having all the knowledge in-house is hard. With cloud and fintech, you can leverage knowledge much better to weather these storms.
- Have robust systems. To know what you have in your books, you need to have robust front-to-back systems, so you can process your trades and not rely on manual processes, plus you need to have controlled, continuous access to the system.
- Cash is king. Knowing your funding alternatives and being able to go to market quickly is paramount. If the government opens a lifeline, how quickly can you get it for you and your clients? Use the cloud.
- Simplicity and timing are everything. Simple products are useful tools that you can easily offer to your clients, build positions, and hedge rapidly and efficiently. In this way, you can ensure service and profitability at the same time.