We’ve taken note of excessive optimism and leverage (see, as examples, “The Rising Tide of Liquidity” and “More Signs of a Toppy Market“).
Now the European Central Bank is also sounding cautionary notes. Ever since Alan Greenspan’s famous “irrational exuberance” observation produced a 140 point (then 2%) fall in the Dow, central bankers have been cautious about commenting on the state of the markets. These remarks are therefore surprisingly direct. From the Financial Times, “ECB warns on ‘unstable’ financial markets:”
Conditions in global financial markets look potentially “unstable”, suggesting investors need to prepare for a “repricing” of some assets, Jean-Claude Trichet, president of the European Central Bank, said over the weekend in Davos.
The recent explosion of structured financial products and derivatives had made it more difficult for regulators and investors to judge current risks in the financial system, Mr Trichet said. “We are currently seeing elements in global financial markets which are not necessarily stable,” Mr Trichet said, pointing to the “low level of rates, spreads and risk premiums” as factors that could trigger a repricing.
“There is now such creativity of new and very sophisticated financial instruments … that we don’t know fully where the risks are located.” He added: “We are trying to understand what is going on but it is a big, big challenge.”
Mr Trichet’s comments reflect a debate in policymaking circles about the implications of the growth in derivatives.
Many investment bankers and some regulators and economists argued at last week’s World Economic Forum in Davos that the growth of the $450,000bn (€350,000bn, £230,000bn) derivatives sector had helped reduce market volatility and made the system more resilient to shocks by spreading credit risk. But other officials fear these instruments may be raising leverage and risk-taking to dangerous levels and keeping the cost of borrowing artificially low, potentially increasing the chance of financial crises.
Senior policymakers admitted it had become hard to track the risks because the sector is opaque, much activity occurs in unregulated hedge funds, and products shift rapidly across markets and between the boundaries of national central banks.
Andrew Crockett, president of JP Morgan international, said: “These new instruments ought to make markets more complete. But there is a lack of transparency … we don’t know how much leverage there is in hedge funds, for example
.”
