STATE STREET: Why the rules have changed

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The wild ride of markets that has kicked off 2016 is set to continue, and the “volatility of volatility is rising”.

That’s the ominous warning from Kevin D. Anderson, State Street Global Advisor’s head of investments for the Asia-Pacific region.

Speaking in Sydney this week, Anderson highlighted six factors that are driving the increased uncertainty in markets which is then flowing into volatile trading conditions.

Anderson highlighted the usual suspects in the uncertainty surrounding China, the path of US interest rates, Europe, and the US presidential election process as well as the geopolitical risks surrounding the Middle East, Syria, Russia, and Europe.

These risks are well appreciated. The difficulty, the one driving the volatility, is how they will play out individually or collectively across the course of the year.

But Anderson also highlighted a dangerous structural shift in market liquidity which is undermining the ability of banks and other market-makers to warehouse risk. That is, in an effort to avoid excess risk on bank balance sheets from their trading activities, central banks and global banking regulators have made it more costly for trading operations of financial institutions to take the long view, and hold assets in distress on their balance sheet as they await a reversal of market prices.

In the past, when Anderson’s other five drivers of volatility have pushed markets to extremes, banks were able to move into the market, buy, put the assets on their balance sheet, and wait for markets to calm down. This in turn stabilised prices, and fear, and helped markets heal.

Because these banks could deploy substantial balance sheet to the markets at times of market fear, or panic, the capital they put to work truncated the most acute phase of most market moves.

But, under the new rules, this is no longer the case. That makes it harder for markets to clear at any given price. That in turn means that prices in 2016 can fall further and faster for any given catalyst than they would in the past.

The impact of this is that at a time when markets appear to be as uncertain as they’ve been since the depths of the GFC there is often no-one, no big bank, to take the other side of the trade, to dampen market moves.

Oil’s remarkable moves in the past two days neatly highlight this point. Wednesday Nymex Crude fell 5% with that move followed up with a 9% rally overnight.

Volatility is two way after all – up and down.

The good news in all this is that SSGA’s Anderson said he doesn’t think market volatility will stay elevated in 2016. But his warning that the volatility of volatility is going to increase in means investors might have a very hard time getting comfortable this year as prices bounce around.

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