When will we know there won’t be another meltdown?

As mentioned the other day, I will be at this year’s SWIFT Show SIBOS focused upon a dialogue around the Long Now. The aim is to find some big super-crunchy questions about the long view of banking and finance, and try to answer them.

What sort of questions are we thinking about?

Here are a few to kick off the grey cell processes:

• When will we know that there will never be another systemic meltdown like the one we’ve just seen?

• If India and China become the world’s leading economies, what will Europe and America be doing and how will financial markets change?

• Can we foretell a future where a human right includes "to not be poor", and what happens to work, life and war if there is no poverty?

• What would banks be doing if the movement of money as a value exchange died out tomorrow? Would banks be needed at all?

• If the world really is in meltdown due to climate change, how will commodity trading change, for example, will there be wars over water?

• Suppose we could travel around the globe in under three hours – just suppose man has created an engine that can get you 32,000 km in under three hours – woud that change anything in financial markets?

There’s a few more like these, and if you have any to add then just mail them to me.

Meanwhile, I thought it useful to start a series of blog entries giving my own perspective on these questions.

First, when will we know that there will never be another systemic meltdown like the one we’ve just seen?

We won’t.

I’ll tackle the next question next week.

 v
vv

v

Oh, go on then, you knew I couldn’t give a short answer didn’t you?

For some years, it’s been well known that the markets rise and fall like breathing. For three to five years, you make profits and find good returns, for the next one or two years, the markets correct and you lose a bit. You win some, you lose some.

It’s an accepted way of doing things and the way the markets work.

But once in a while, a bubble forms that does not get reined. It steams and blows, and gets bigger and bigger until its fit to burst.

Imagine it is like blowing bubble gum.

You blow bubbles with the gum and most of them just go out and pop, or go out and come back in again.

Then you get a bubble that’s the biggest you’ve blown all day and you don’t know what to do with it, so you keep on blowing.

You blow and blow until the bubble is the size of your head.

Then the bubble bursts and splats all over your face.

Luckily that rarely happens but, when it does, it leaves a massive horrible mess all over that’s difficult to clean up.

That sounds pretty much like the financial markets.

So how do we ensure the bubble doesn’t grow so big or burst so messily again?

Well, it’s not a matter of regulation, but more a market-led model of effective risk management.

Now we thought we had that in place pre-2008, but it obviously was not the case in hindsight.

Pre-2008 we focused upon market, credit and operational risk; now, we focus upon liquidity risk; in the future, there has to be more focus upon systemic risk circuit breakers.

What do I mean by systemic risk circuit breakers?

Basically systems that can monitor the interlinkage between firms, instruments, portfolios and assets, and alert when a total trade position of a trader, institution or market is systemically important and at risk.

That’s what we should have had pre- the collapse of Long-Term Capital Management (LTCM), and it’s what we should have had pre- the collapse of Lehman Brothers.

However, the two collapses were caused by different circumstances using different instruments. This is why the systems need to monitor across asset classes, across markets and across regions.

I’m not saying that’s an easy thing to set up or introduce, although the single data repository of the DTCC is the first attempt to track such things.

But I don’t think we can truly feel that another meltdown like the last one can be avoided until we have true tracking of all risk exposures globally in real-time on a central platform.

Yow! That sounds far too much like Big Brother.

And yes, it would inhibit trading because you would be concerned about your market movements being tracked so studiously.

Equally, who’s doing the tracking?

An independent neutral body?

A government?

A regulator?

Nah ... not sure if we’ll ever get to the stage where you could truly operate a capital market system with full pre- and post- trade transparency on a globalised basis through a single platform and view.

But, without that, we will never be certain that the markets can avoid another systemic meltdown.

Catch 22?