Guest article written for AllAboutAlpha.com – the official publication of the Chartered Alternative Investment Analyst (CAIA) Association
One of the most astonishing revelations of the past decade has been how little we really understand about risks in our financial markets. The ‘once in a thousand year‘ events which previously inhabited the extreme end of the left-tail are (increasingly) manifesting in our markets leaving devastating consequences. Just because we don’t know much about it, doesn’t mean that businesses in the financial sector are not doing all they can to make it easier for everyone, whether you are a customer or another business. When it comes to banks, complying with CECL Implementation is very important, to improve business relationships by managing risks. This may be something worth looking into if you are not familiar with this idea.
One of the key fallacies has been our assumption that vast quantities of data about the past will reflect clues into our future. While there will be certain truths in this, the fact remains that not only does the speed of geopolitical and economic change far outpace our ability to understand it, but the number of participants in the economy can also introduce a huge amount of emergent risk. This latter point was illustrated well by the Economist who noted, “…If people do make history, then two people make twice as much history as one. Since there are almost 7 billion people alive today, it follows that they are making seven times as much history as the 1 billion alive in 1811. This century has made an even bigger contribution to economic history. Over 23% of all the goods and services made since 1AD were produced from 2001 to 2010…” (don’t forget that much of our modern day economic insight is based around theories which emerged in the 1800’s, built around the logical structures of a far simpler world). Alongside this the financial markets are rapidly becoming a new theatre for conflict. As a key member of the U.S Air Force Intelligence Crisis Action Team notes, “…the leading edge of tomorrow’s warfare is economic.”
To understand more about the ‘forgotten‘ and ‘ignored‘ elephants in the room, we speak James Rickards (author of ‘Currency Wars‘) who is Senior Managing Director at Tangent Capital Partners LLC, a merchant bank based in New York City, and is Senior Managing Director for Market Intelligence at Omnis, Inc., a technical, professional and scientific consulting firm located in McLean, VA. Mr. Rickards has been a direct participant in many of the most significant financial events over the past 30 years including the release of US hostages in Iran in 1981 and the LTCM hedge fund collapse of 1998 in which Mr. Rickards was the principal negotiator of the government-sponsored rescue. Since 2001, Mr. Rickards has applied his financial expertise to a variety of tasks for the benefit of the U.S. national security community and the Department of Defence.
Q: What are the key security threats faced by our financial markets, and what would be the implications should they manifest?
[James Rickards] There are really two aspects to security threats to financial markets. I divide the financial markets into the ‘physical’ and the ‘intangible’.
The physical would be the infrastructure… fibre optic cables, computer servers, routers, switches, messaging systems… all the ‘plumbing’ needed to keep the capital markets going. That’s obviously vulnerable to two threats. One being physical destruction (explosions and acts of sabotage) and the other being cyber-attack. The good news is that these systems, at least in the United States, are much more robust than before. Before 9/11 a lot of critical systems were located in Lower Manhattan. Since then, they have been dispersed to different locations, different power grids and a lot of redundancy has been built in. Cyber-threat is the single most serious threat faced by the markets. The United States is very good at cyber warfare and counter warfare, but so are others. This is what we call ‘asymmetric’ warfare where adversaries have been able to level the playing field. Many countries cannot complete with the United States in conventional military warfare, but in the cyber wars? They can go toe to toe. I think this really harps back to the 1960’s and 70’s era of M.A.D (Mutually Assured Destruction) where both sides would have nuclear weapons, but were each afraid to use them as they knew there would be retaliation. Likewise I think a country would think twice before cyber-attacking another because even if it were somewhat successful they would be the victims of an attack themselves. The wildcard there are criminal gangs…. Even if the US and China constantly probe each other; there are criminal gangs and other malicious actors who may take it further. This could cause market failure and closure and is very hard to predict.
The other broad area is the ‘intangible’ or ‘the soft infrastructure of trust and credit’. Here what we’re talking about is not so much physical destruction, but would involve a foreign power using financial resources to create hedge-funds or other anonymous players who… with enough funding… would gain leverage and trust and be viewed as just another hedge-fund with a funny name based out in the Cayman islands. People would be unaware of their true attentions and then on a certain day, they could act in co-ordination and flood the market with sell-orders. A lot of people are sceptical about the ability of an actor to move markets around like that as markets are so large. I wouldn’t underestimate it though…. I think someone trying to do that would use a force multiplier. They would act on a day where the market was down already… even just 4 or 5% based on some bad news. On that day, they would pile-in with tens of billions in sell-orders to try to drive the market to the point of collapse. These are very real threats which are out there. There are some defensive measures being taken, but it’s naïve to think that financial markets are not part of the battlefield.
Q: What are your views on the currency-market being used as a theatre for financial warfare?
[James Rickards] This has moved very quickly from the theoretical to the real. Let me give you a concrete example… In 2009, the Pentagon conducted a financial war-game that involved the use by China and Russia (and potentially others) of Gold to back a new currency alternative to the Dollar and, in effect, marginalise the role of the Dollar in world financial markets and ultimately as a reserve currency. That’s something that I thought realistically might play out over four or five years but here we are in 2012, we’re seeing real financial warfare between the United States and Iran. Here we’re not talking about gaining some trade advantage by weakening their currency (something which goes on all over the world)… but rather that the President of the United States announced sanctions against Iran which, in effect, forced them out of the Dollar payment system globally. This effectively was a message to other banks that if they did business with Bank Markazi (the Iranian central bank), they may not do business in the Fed Wire, Dollar payment system, CHIPS and other clearing houses. This was extremely effective… The value of the Rial (the Iranian currency) dropped over 40% in two days. This was a clear currency collapse! It immediately injected hyperinflation into some areas of the Iranian economy as merchants who wanted to import suddenly had to double their local currency prices to fetch the same amount of Dollars in the black market or elsewhere. The banking system then began a run on the Rial. People felt the currency was depreciating rapidly and tried to get their money out of the system. Rates suddenly rose to 20% to retain interest in Rial denominated bonds and deposits. We were able to trash the currency, inject hyperinflation and cause interest rates to skyrocket… all at the same time… through the use of a currency weapon. I don’t think it’s a coincidence that this is all happening weeks before Iranian elections. It has the appearance of an effort to stir a popular discontent and perhaps restart the green revolution. This is a real world, real time example of a currency weapon being used…. Not to gain trade advantage, but to destabilise a regime. The reaction has been equally interesting. Iran has gone out and said, “…If you’re forcing us out of the Dollar system, you’re forcing us to create an alternative…” and they’re now very far along with discussions with India to pursue various barter arrangements…. Oil for Wheat, Oil for Food and so on. Furthermore, the Iranians have agreed to accept the Indian Rupee in payment for Oil which the Iranians can then use to purchase Indian goods. For every action, there is a reaction, and while the US were effective I feel we are starting to see the stirrings of a non-dollar payment system. One can imagine Russia, China, Iran, India, Central Asian Republics and others putting up their own messaging system as an alternative to SWIFT and using local currency, barter and Gold as an alternative payment system. This is all happening far more quickly than we previously realised.
Q: Are there any risks the markets pose to themselves?
[James Rickards] The greatest threat to our markets comes not from our adversaries but from ourselves. I think Ben Bernanke’s policies are a greater threat to US national security than anything being cooked up in Moscow.
My other concern is that banks are so bent at using expanded balance sheets, using derivatives, using off balance sheet, confusing the net with the gross, pretending that risk is in the net when it’s really in the gross, pretending that risk is a linear function of scale when it’s an exponential function of scale… and other such blinders which may destroy the markets before science is able to fix it.
Q: Do you think financial markets exacerbate threats in other areas such as terrorism?
[James Rickards] Yes… to the extent that you create these very large-scale highly-interconnected complex systems and… as the saying goes… the bigger they come, the harder they fall. My own twist on that is that the bigger they come, the exponentially harder they fall!
I think the United States and allies around the world have done a very good job of containing the ability of terrorists and criminal gangs to access the financial system. I’ve been in the hedge-fund business a very long time. I can recall in the 90’s when one wanted to set-up a structure offshore you could just call your law firm or bank in the Cayman islands and they would literally read you back the account numbers over the phone. Today? It can take a week or even weeks for totally legitimate operators to open an account given the due-diligence that is now required. Responsible financial institutions have done a good job in that regard, but there are still channels there for use of penetration by others. I worry more about the soft attacks than the hard attacks. For the more sophisticated players who know how to use corrupt or unwitting lawyers and bases such as Cyprus, Malta and so on… they can pose a real threat.
Q: Do you think risk managers and policy makers really understand this threat?
[James Rickards] Most risk managers on Wall St, and practically all staff members in institutions like the Fed, IMF and elsewhere do not understand the statistical properties of risk. I think the notion that the time-series of market moves in large complex markets is not a normal distribution has largely sunk-in. Nasim Taleb did a good job of destroying the bell curve in his book ‘The Black Swan’. He also threw up his hands and said, ‘stuff happens, there’s not much we can do about it!’. I don’t agree with that.. I agree completely that normally distributed risk, efficient market hypothesis, Value at Risk, the efficient frontier… all the tools in modern finance are basically false science. I don’t think that makes the case hopeless. There are good analytical and mathematical bases to understand risk but people have been very slow to adapt. Using complexity theory, network science, behavioural economics and other tools, it is possible to shape a paradigm that gives one a better insight into how risk works. This stuff is, unfortunately, still in the laboratory. It could be years before this stuff gets into the mainstream, but it’s a place to start…
What does this mean for investors and risk managers?
It is, perhaps, because a lot of these eventualities sound like they would emerge in the world of film rather than real life, that risk managers and investors don’t feel they are relevant. The truth is that within the financial architecture of the world there are a lot of threats (internal and external) which, if manifest, could have extreme consequences for participants in the market- and the economy as a whole.
Risk managers and investors have long been ‘selectively blind‘ to these threats simply because to admit them means a total change in their thinking. Now… however… the choice is somewhat more stark. Either they can proactively change their thinking, or wait for a devastating market event to change it for them…….