Gale Warning on Market Risk Management

On Friday, in a single forward-market trading session, gold lost 5.8% of its value, and silver lost 17.8%. Considering the present state of the financial markets and the overall condition of the economy, which for the past few weeks has been entering the second phase of the ‘W’ double dip which began in 2007, this might seem surprising, precious metals constituting the very prototype of the safe-haven investment.

In reality the fact that precious metals – particularly gold – have been rising steadily since February should be interpreted in hindsight as a sign that the financial markets were in relatively good shape in the first three quarters of the year. For the price of gold and silver is falling at the moment not because they have ceased to be defensive investments but because some investors who had bought into them are selling them at the moment, not for the purpose of profit-taking but because they are unable to do otherwise, as they are having to pay off debts which they are incurring elsewhere or because the clearing houses in markets in which they have investments are issuing them with margin calls, i.e. requiring them to increase their funding reserves in consequence of their losses.

In other words, the sell-off of gold and silver that we witnessed last week and particularly on Friday amounts to nothing other than emergency selling by market players in difficulty. One person questioned about this by the Wall Street Journal yesterday remarked that “it seems as if the European banks are selling gold, possibly with a view to increasing their available liquidity and shoring up their balance sheets“.

When we enter into a period of clearance sales in the financial markets, like the sell-off of precious metals that took place all day long on Friday, we may say that the collapse is spiraling out of control. Managing market risk depends on the prices of certain products rising while the prices of others fall. Now, when everyone is getting rid of everything because there really is no choice, as is the case at the moment, the prices of all products collapse at the same time. Covering financial positions – protecting them against loss by taking positions on products whose prices are rising – is no longer possible, and so risk management descends into chaos. This is what happened on Friday, when losses which they incurred forced certain market players to divest themselves of a certain type of asset held by them. Such a large quantity of assets being offered for sale all at once caused the price to fall, leading other investors to incur losses, which forced them to sell too, and so on and so forth, creating a diabolical spiral.

The misadventures of Mr Adoboli at Union de Banques Suisses, which came to light last week, were disturbingly reminiscent of those of Mr Kerviel at the beginning of 2008. The Friday clearance sell-offs themselves thrust us back into the frenetic atmosphere of 2008. Unlike his counterparts at Société Générale who have chosen to stay in post, Mr Oswald Grübel, CEO of UBS, preferred to resign on Saturday. How should one interpret this gesture? A revival of a sense of honour in the management of banks? Or, rather worryingly, simply throwing in the towel?

[English translation of my September 24 post: Avis de gros temps sur la gestion du risque de marché on my French blog by Frankly. Thanks, Pal!]