Where Will Risk Erupt This Time?

So where has all the risk pooled up in the system? In foreign exchange (FX) markets, that’s where.
One of the precepts of this blog is that risk cannot be disappeared, it can only be transferred or temporarily hidden from view. This runs counter to modern portfolio management, which holds that all risks can be hedged with counterparty-issued securities, i.e. options, futures contracts, derivatives, etc. This also runs counter to the Central Banking Cargo Cult, which holds that any eruption of risk can be smothered by the unlimited liquidity spewed by omnipotent central banks. There are several problems with the notion that risk can always be neutralized with counterparty securities and/or central bank liquidity. The first is fundamental. As mathematician Benoit Mandelbrot showed in his seminal book The (Mis)behavior of Markets, risk is a feature of all markets. As a result of their fractal nature, risk cannot be eliminated, and claims that risk has been eliminated will fail catastrophically.
In other words, precisely what happened in 2008-2009, when all the “low-risk” trades blew up and nearly took the global financial system down. The second reason has to do with the failure of conventional models to assess tail risk. As former Federal Reserve chairman Alan Greenspan confessed in Foreign Affairs, Why I Didn’t See the Crisis Coming, the Fed’s models failed to accurately account for tail risk (otherwise known as things that supposedly happen only rarely but when they do happen, they’re a doozy), because guess what–they happen far more often than statistical models predict.

This post was published at Charles Hugh Smith on NOVEMBER 09, 2014.