Markets on the front line of global risk

Humanity isn’t becoming desensitized to tragedy, the financial system is becoming more organized in managing the fallout.

This article was originally published April 19, 2016 on Byline Times

Shortly after the Brussels bombing, Société Générale weighed in with a commentary on the state of affairs: “Sadly, global markets are getting used to terror attacks.” The tragic events, the French bank noted, may have tamed the generally buoyant risk conditions prevailing after a dovish Fed meeting, but the effect was short-lived and the impact on bonds minimal.

The clearest effect of the terrorist attack was in FX, and BlackRock’s Global Chief Investment Strategist, Richard Turnill, noted that so-called safe haven currencies such as the USD and Yen rose. Otherwise, it was business as usual, albeit with respect for the collective outpouring of sympathy felt all over the world for yet another city suffering from familiar grief.

SocGen’s ‘sadly’ comment, although understandable, could also be considered through a different lens: it’s not that humanity is becoming desensitized, it’s the financial system becoming more organized.

The financial system is a type of front line in the fight against terrorism. When Daesh swept through Iraq and Syria, it gained an estimated $1.5 billion from looting banks and oil sales (oil sales estimated at $40 million per month), noted Adam Szubin, Acting Under Secretary for Terrorism and Financial Intelligence at the US Treasury, speaking at Chatham House in London in 2015.

The combat strategy? Cut all affected banks from the international financial system, which is done, and stop Daesh fund flows at the oil well head, he added.

Disruptive calamities

Disruptive global risks and tragedy is certainly not limited to terrorist attacks, and markets play a critical role in the response to natural hazards.

Although there is much to note about the way that local and international bond, equity and commodity markets, combined with the non-profit and microfinance sectors, worked together during the Pakistan floods of 2010 to mitigate the tremendous risks to societies both within the country and in the global community (think: nuclear weapons, for example), one specific area of mention is the way CDS (credit default swap) rates responded.

Pakistan’s rural populations found themselves displaced and cut off from basic necessities with 20% of the country under water, and global appeals for help resulted in large and much-needed donations pouring in. CDS rates on bonds started to rise as risk models began calculating and people questioned the government’s chances at staying in power.

The last thing Pakistan needed at that moment was for its cost of debt to rise unsustainably. Credit rating agencies Moody’s and Standard and Poor’s assessed the situation as stable, in part due to the global charitable cash injection. CDS rates stabilized immediately. This, at a time when Ireland was being downgraded during Europe’s sovereign debt crisis.

As fallout from the recent double whammy of earthquakes in Ecuador and Japan continues, the gearing up of insurers and reinsurers is also immediate, with damage assessments starting to stream out as a precursor to deploying resources for people to rebuild lives.

The earliest preliminary reports from the US Geological Survey (USGS) use estimates of recordings of ground shaking, correlated with population density and databases of building infrastructure to estimate fatalities and economic losses. In Japan, estimates show there is a 72% chance that losses will surpass $10 billion (30% chance losses will be greater than $100 billion), while in Ecuador, there is a 32% chance that losses will be between $100 million and $1 billion.

In such conditions, the importance of functioning markets to help people cope with the aftermath can’t be underestimated, nor can the crucial necessity to coordinate civil society efforts with markets functionality, an element in which advanced technologies fomented by the financial industry (and military) are playing an increasingly important role.

During the Nepal earthquake of 2015, for example, artificial intelligence was part of disaster relief efforts, with machine learning technologies assisting humanitarian agencies to convert big data into informed, decisive action on the ground.

It’s the emergence of crisis management in the 21st century at a time when portfolio managers are starting to wonder whether their future can go the way of the robots, like it did for traders.

Only change is certain

There’s really only one certainty: rising risk and greater volatility in the context of human tragedy isn’t going away, and markets are set to cope not just with the realities of maintaining stability in the face of terrorism, real and cyber, and in the wake of natural hazard events, but also address the linked relationship of such events to global climate change.

Today, Yemen is at war. But in 2009 leaked cables show US diplomats warning about the existing desperate state of affairs.

Under the heading “Water Shortage Threatens Stability”, then US Ambassador to Yemen, Stephen Seche, writes: “Dr. Abdulrahman al-Eryani, Minister of Environment and Water, expounded upon Yemen’s ‘insidious’ water crisis and ways to ameliorate it. Eryani described Yemen’s water shortage as the ‘biggest threat to social stability in the near future.’ He noted that 70 percent of unofficial roadblocks stood up by angry citizens are due to water shortages, which are increasingly a cause of violent conflict.”

The IPCC (Intergovernmental Panel on Climate Change) — established by the World Meteorological Organization and United Nations Environment Programme — is at the forefront of linking the confluence of such global risks: “Climate change is projected to increase displacement of people (medium evidence, high agreement). Populations that lack the resources for planned migration experience higher exposure to extreme weather events, particularly in developing countries with low income. Climate change can indirectly increase risks of violent conflicts by amplifying well-documented drivers of these conflicts such as poverty and economic shocks (medium confidence).”

Syria is, of course, the current poster child for the consequences of so many factors coming together to devastate a region and its citizens, who are now fleeing in the millions to neighbouring countries and Europe. There doesn’t seem to be any solution in sight.

As the world faces such threats, so too do the markets connecting it. Integrating ESG (environmental, social and governance) risk management into the investment process is getting discussed and asked about more and more at industry conferences.

And for all the complaints about fragmentation, an ecosystem of numerous and diverse markets has clear strategic benefits: no one center can be crippled by any one event.

Across asset classes, market structure is adapting to fragmentation and the accompanying electronic channels that connect its proliferating nodes. It’s meant that market players have to accept managing more volatility as part of doing business in a rapidly changing environment.

But it’s also a reflection of the challenges in store, and the coping strategies deployed today in a post-financial crisis reality provide a window into what establishing processes of resilience and stability will look like in the future.