One of the most interesting can potentially arise when a particular market is characterised by traders who are structurally short options, have short holding periods, and are leveraged; and where the underlying markets are not highly liquid. That needs a bit of unpacking. Options can, of course, be hedged with an offsetting position in a similar option: a so-called ‘static hedge’. Where, for one reason or another, traders cannot do that, they can attempt to hedge by running a position in the underlying instrument, with the intent that gains or losses on the value of their option positions will be offset by losses or gains on the underlying asset position: a so-called ‘dynamic’ hedge. It’s dynamic hedging that can be interesting. The effects of dynamic hedging of long and short option positions can be quite different. Broadly, dynamically hedging a long option position entails selling the underlying as prices rise, and buying as prices fall. Conversely, those who have sold (or written) options need to buy to balance their hedge when the value of the underlying is rising, adding to the buying pressure. And, if the price of the underlying instrument is falling, they need to sell to balance their hedge, adding to the selling pressure. This is, of course, going on every day in a wide variety of deep and liquid markets without anything particularly odd happening to market dynamics. Things are potentially more interesting when markets are structurally imbalanced, with short-term traders, dynamically hedging, concentrated on one side.
Ex ante, they won’t know for sure which is which. Plausibly, it might not be economical to put controls in place for every single innovation on an assumption of ‘exponential growth’. So when exponential growth occurs, controls can sometimes be left behind. Maybe something like that helps to explain the backlog in credit derivative confirmations, which the FSA cautioned banks about a few months ago. Growth in the market has been relentless. And to the concerns about confirmations have been added concerns, amongst practitioners, about unnotified assignments of credit derivative positions, related in part to the growth of hedge fund participation in the structured credit market. If something really bad were to happen, the system would, perhaps, be less robust than otherwise if dealers were not sure about who their counterparties were, etc. This is the type of challenge where collaboration across the industry is needed; and where individual firms’ incentives are stronger if they can each be confident that their peers are taking broadly the same actions. What I have in mind is the disincentive a firm faces in being tough with a hedge fund client if they doubt their peers will take the same line. Bodies such as ISDA have a role to play here, and I understand are doing so. Collective elements in atomistic markets So, where are the risks? They are all around us all of the time, of course. Some will crystallise. But that need not lead to disorder.