A new normal?
As published in FF News on December 20, 2022.
Technology and regulation have moved on since the last global recession, giving investors better tools to navigate what looks likely to be a year of extreme uncertainty – one in which none of the old rules about economic performance seem to apply. We asked two leading providers to the market – Christian Kahl PhD, President of FINCAD, the capital markets division of Zafin, and Gennadiy Friedman, MD of Enfusion – for their analysis.
THE FINTECH MAGAZINE: How do market conditions today compare with the financial crisis of 2008 and how have changes since then shaped the current environment for hedge funds?
GENNADIY FRIEDMAN: After 2008, hedge funds went through significant regulatory and risk management changes. Now, most hedge funds are required to be registered. There’s also a big emphasis on due diligence and transparency. The introduction of UMR, which stands for uncleared margin rules, has increased the focus on collateral management practices. Initial margin is almost entirely value-at-risk (VaR) stress-test-based these days, and, overall, margin optimisation is playing quite a significant role in the trading decision-making process. Liquidity management, through daily monitoring of the unincumbered – or free – cash, has become an important part of overall cash management, so managers know how much is available at any point of time.
As for models, counter intuitively, there was too much reliance on them in 2008. This was especially the case with quantitative funds, which had interrelated and highly correlated positions, meaning they effectively had the same positions on the books. Today, many quants recognise the same type of risk, and use appropriate hedging techniques.
CHRISTIAN KAHL: Data analytics and computing resources are vastly different to what was available in 2008. Today, Cloud capabilities can increase frequency of calculations to almost real time. Data storage, how data is made available and at what speed has also vastly improved. This allows for much better oversight of inherent risk in the investment industry. Modelling and analytics have also evolved dramatically with market, counterparty, collateral and liquidity risk management, and practices allowing institutions to stay ahead of market turbulence. Model risk management, as well as regulatory oversight, is entirely different from what we saw before 2008. Financial regulation, in particular on the sell side, is much stronger due to regulatory minimum capital requirements under Basel III/IV and as part of the Fundamental Review of the Trading Book (FRTB). On the buy side as well, it’s common to see a strong focus on model validation and back testing, all of which have been eased by computational performance and scaling, so that analysis can be performed in near real time. Scenario analysis is more routine than ever.
TFM: What can we learn from events of the last two years and the way they have shaped trading strategies?
CK: The market of 2021 was very friendly for asset prices. The monetary policy undertaken by central banks, and further stimulated by governments, counterbalanced the impact of COVID-19. Asset prices have gone in only one direction – up. And, with the end of the various forms of lockdown, the housing market went the same way. This ‘rush’ in 2021 wasn’t sustainable. We’ve faced a severe labour shortage, and it was almost certain that inflation was on the horizon. In the US alone, it’s estimated that the labour market lost close to half a million people after COVID-19 lockdowns, and that’s on top of the people who have passed away through the pandemic. Investors are under stress to meet and make their returns, and risk management is extremely important. Modelling, and paying attention to the detail, is vital. One of the most intriguing market events in 2022 was the UK mini Budget crisis, which caused a sell-off of UK gilts.
Falling gilts triggered a feedback loop, with UK pension funds having to sell further gilts to fund collateral calls against derivative positions. Ultimately, the Bank of England had to intervene to calm markets. Overall, being extremely cautious around modelling is at the forefront of current thinking because investors don’t want to repeat the mistakes from 2008.
“Overall, being extremely cautious around modelling is at the forefront of current thinking because investors don’t want to repeat the mistakes from 2008.“
- Christian Kahl PhD, FINCAD
GF: The monetary policies during the pandemic injected liquidity in the market. In general, it takes anywhere between 12 and 18 months to see the full impact. In 2021, we saw the strongest economic growth in the US since 1984, somewhere around six per cent. Cheap money, low unemployment, combined with a growth in personal income, created the foundation for the perfect storm. A lot of trading in 2021 was less fundamental rather than opportunistic. And that’s where we’ve seen quite a few funds get caught in this game. So, the lesson learned is the importance of understanding and actively managing the risk, and the possibility of a tail impact.
We’re now talking about high rates, high inflation, the war in Ukraine, the impact of the energy sector, especially in Europe, and other geopolitical and economic events. They’re all laying solid foundations for macro hedge funds to do quite well, especially for systematic macro strategists. From the risk perspective, funds are focussing on VaR, usually not a single VaR, but multiple. It could be parametric and historical VaR, or Monte Carlo [a risk assessment tool that uses simulation to answer the ‘what if’ question, which is not possible under historical simulation], and a variety of stress tests, including standard stress scenarios. Aside from the global macro systemic trading, we can see a shift to fundamental trading in the credit space, especially among the distressed credit funds.
Another thing is the demand and activity in the exotic FX and volatility products space, which are products with a very complex P&L profile. We’ve seen our clients and potential clients, asking for things like triple digital FX options, dual digital kick-in/kick-out, and digital constant maturity swap (CMS) spread, for example. That begs the question of modelling. Our flexibility and fully-customised environment in Enfusion allows clients to fine-tune modelling. And they can do this, in some cases, without even touching the code; it’s all part of configuration. That flexibility of fine-tuning your approach to risk management, is a tremendous advantage that we provide through our partnership with FINCAD.
TFM: With rising inflation and supply chain disruption, what can investors expect in the near to mid-term?
CK: Inflation will dominate financial markets for some time to come and investors are well aware that this is a long-term trend. Looking at the inflation swap markets, we see that at the three-year time horizon in the UK and Europe, swap rates trade at five and three per cent respectively; that’s well above the central banks’ inflation target. This has profound impacts on the rate-setting of central banks. Yield curves are set for further interest rate increases, with a very steep curve at the front end. We can observe a worrying sign in the middle of the yield curve, which is inverted. This has historically been a strong indicator of recession. So, what we’re facing is high inflation and interest rates that have been raised both distinctively and rapidly from historically low levels with further rising rates to come. Supply chain disruption has certainly made inflationary pressure worse.
It’s not certain, however, that increasing interest rates will suffice. And here, we’re identifying something that’s critically important: what we assumed might be normal may not be. One only has to look at historical assumptions about asset price movements, with traditional paradigms on correlation of assets breaking down over the last couple of months. Let’s not forget the LIBOR transition as well, as the entire capital market industry is still figuring out how to standardise the market for interest rate and interest rate volatility instruments.
“Aside from the global macro systemic trading, we can see a shift to fundamental trading in the credit space, especially among the distressed credit funds.“
- Gennadiy Friedman, Enfusion
GF: Inflation in the US hit a 40-year high recently, and it’s putting tremendous pressure on company earnings because the high cost of capital impacts stock performance. According to the September jobs report, the economy added more than 260,000 jobs. That seems great news, but it also creates additional concerns about the potential future rate increase. Historically, every recession since the mid-50s has generally followed the inverted yield curve that Christian talked of. And, on top of that, there’s the impact of COVID-19 and the war in Ukraine, which has created long-lasting damage to supply chains.
TFM: What strategies should investors consider in this environment?
GF: Investors are looking for risk-adjusted returns on capital, which means a high Sharpe ratio, which compares investment returns with associated risks. There’s definitely more transparency in investment portfolio strategies, and you can see plenty of good due diligence these days. There is more demand for operational precision and control, and when it comes to risk management practices and valuations, it’s not just about real-time risk in P&L, and time series analysis, or various stress tests. It comes down to internal risk policies and procedures, including decoupling the trading and risk functions within the organisations. So, we’re definitely entering a new regime, characterised by tighter financial conditions, less liquidity, high volatility, and generally higher risk premium.
This creates opportunities but also raises questions.If you look at ESG investing, the war in Ukraine has created new concerns for investors: oil and natural gas companies have delivered a tremendous year-to-date return, however, sustainable and socially responsible investing is an irreversible trend with a longer time horizon. Quantitative trading is another important strategy, enabling portfolio managers to rebalance portfolios relatively quickly, within less than 30 days. At the other end of the spectrum, you have systematic macro hedge funds, whose approach goes far beyond traditional long/short equity.
CK: Investment opportunities are about spotting trends, patterns, and anomalies. Rapidly raising rates and inflation provide great opportunities for investors in distressed debt and convertible markets, provided one has the analytical tools to analyse and compare markets holistically. Another area that is generating interest, of late, is volatility instruments. In an uncertain market environment, investors are looking to diversify their portfolios, while also working to minimise risks. Volatility instruments, such as variance swaps, volatility swaps, Volatility Index (VIX) futures and options, and other volatility products can often help investors attain these goals.
“We use the Cloud to bring our products and services to our clients through APIs, effectively supplying analytics as an industry utility.“
- Christian Kahl PhD, FINCAD
TFM: How does your technology help you say ahead in a highly competitive market?
GF: Enfusion is a fully Cloud-based solution, with single and multi-tenant models, which effectively eliminates the need for software updates or maintenance. This is a tremendous advantage. Our partnership with FINCAD empowers our clients with a robust analytical library that can handle a variety of complex products under different model assumptions and market conditions, and we can quickly adapt and respond to their needs. When clients try to model something that we don’t have a function available for, that’s where the partnership and brainstorming come together. The ability to work as a team to find different solutions, enhancing our models to handle more complex structures, and continuously calibrating models, help us meet our clients’ needs, and deliver solid analytics across multiple asset classes. Apart from superior analytics, and the pricing capabilities which power our entire platform, the FINCAD team fully understood what it takes to build a strong business relationship.
CK: Cloud adoption is no longer optional these days – it’s the key to staying competitive. Looking across our OEM partners, those who have embraced Cloud technology fare extremely well, and Enfusion is the leading example of that in the hedge fund industry, providing a market leading Cloud-native solution. FINCAD offers a unique value proposition: combining best-of-breed analytics with Cloud-native technology in two ways. First, we embed that into our development processes, and our CI/CD philosophy is built on a vast suite of unit test cases across our build systems, with automated software regression that is completely Cloud managed so we can respond quickly to demands. Second, we use the Cloud to bring our products and services to clients through APIs, effectively supplying analytics as an industry utility.
Additionally, our libraries are not black boxes. They come with transparency tools and utilities that ease internal consistency and model validation requirements, whether that is tracking behaviour, tweaks, benchmarking against results from other available models, or checking with alternative numeric or methodologic approaches. We are transparent in how we engage, and our libraries are very accessible.
The buyer’s onboarding journey is top of mind with whatever software we produce. You can program against our interfaces in various programming languages (Java, NET, C++ and Python) and results can be locally reproduced in Excel, Jupyter Lab, or VS Code, which means Excel and Python are an ideal tool for validation and testing. It’s critically important to run analytics both locally, as well as offload calculations seamlessly to the Cloud. Finally, it is vital to work with our partners to provide a whole product proposition. Enfusion offers market-leading Cloud-native technology, which enables FINCAD to significantly expand our addressable market. We are proud to have been with Enfusion on this journey: it’s a prime example of a partnership working extremely well for our clients.
“When clients come to us and try to model something that we don’t have a function available for, that’s where the partnership with FINCAD and brainstorming come together.”
- Gennadiy Friedman, Enfusion
TFM: What are your predictions for 2023?
GF: The key economic transitions are likely to be driven by the slow recovery of supply chains. Geopolitical tensions could certainly limit the recovery. The Russian energy standoff with Europe will probably intensify the search for alternative sources of energy, and the high cost of fossil fuels will create investment opportunities in renewables. High interest rates will probably stay, and there is a possibility of a recession. These and other factors will likely increase the shift for some money managers toward more systematic trading and fundamental research.
CK: The indicators are set for a very volatile market over the next 12 months. With rising rates and, in particular, differences in the levels of rates for various economies, we expect a continued uptick in volumes of FX derivatives, structured products and volatility derivatives. I can’t see the stock market rebounding from the 2021 heights, particularly with anticipated rate rises and indicators of global recession.
Cryptocurrencies and decentralised finance in general, will continue to be a focus; however, reliable predictions are difficult. The energy sector will undergo a huge transformation, both from the pressure of global warming, but equally to cut the dependency on Russian gas and oil, and the trading of carbon credit will be more in the spotlight. Fixed income markets will further move towards electronic trading in the coming years. We see that high volatility requires strong market and counterparty credit risk management, and anticipate further adoption of data-driven approaches to quantitative fixed income trading strategies.
This article was published in The Fintech Magazine Issue 26, Page 38-39.