It's always margin calls that bring markets to crisis
Commentary by Kathleen Tyson - October 20, 2022
This week marks an anniversary for my career in financial stability and comparative market structure. 35 years ago the Dow Jones Stock Index plunged 22.6% in a single day, a crash that echoed around the world as the first global systemic financial crisis.
I had joined the Federal Reserve Bank of New York in May, and within weeks was told I was responsible for futures, options, and something new called swaps. I asked what those were. The officer responded, "We're not sure either. Go buy some books at lunch and find out." Back then New York couldn't find Chicago on a map. All that was about to change.
I did buy three books at lunch, and I read them. So on Black Friday when I was taken to President Gerry Corrigan's office with that same officer, I was able to explain that the billions in cash being demanded from Chicago banks every hour were required to meet clearinghouse intraday variation margin calls as selling in New York drove the Chicago indexes lower and lower. I explained that the Chicago clearinghouses were making intraday margin calls for cash to cover the risk of defaults on the indexes. I was also able to assure Corrigan that the money would be back in New York within an hour as the clearinghouses would pay winners from the variation margin received from losers.
More selling in New York to raise cash for margin calls led to lower indexes in Chicago and so more margin calls. The doom loop was later linked to 'programme trading' sold by banks as a form of portfolio hedging.
Corrigan called the New York banks and told them to keep lending. The next day Alan Greenspan landed at Dulles Airport and made his famous 'whatever it takes' comment, the first 'Greenspan put'. The Fed dropped interest rates and the markets swiftly recovered their losses. Derivatives boomed as a new industry, and swiftly globalised as a cheap way to buy and sell exposure to a wider mix of assets.
I was there for the first central bank bailout of over-leveraged banks and investors. Afterwards I was a founder member of the Settlement Systems Studies Group to map market dependencies and the drivers of systemic stress and contagion.
That's why the UK gilts market crisis this month rings so many bells for me. The pattern is the same. The LDI portfolio insurance derivatives sold to UK pension funds were the same as 1987 programme trading in driving the crisis dynamic. Negative yields forced pension funds to buy LDI portfolio insurance against falling rates. When rates rose, pensions were forced to sell assets to meet LDI bilateral margin calls. As pension funds sold gilts in the cash market they drove gilt yields higher, so the LDI derivatives soared even higher still. Each wave of gilts selling generated the next wave of LDI margin calls. Another doom loop. It's always margin calls that destabilise markets. The Bank of England broke the doom loop with more intervention.
Warren Buffett called financial derivatives "financial weapons of mass destruction". He had a point.
We could have banned financial derivatives in 1987. We didn't. Now it's too late. And we still don't fully understand derivatives, market dependencies, systemic stress, or contagion.