risk versus uncertainty

Most of the time, markets exhibit “normal” behavior and the inaccuracies induced by the invalidity of the assumptions are not too erroneous, but then most of the time a bank’s expected losses are easily absorbed by its earnings from fees, commissions and bid-offer spread. The only times when a bank needs capital to absorb losses is during extremely stressful market periods when markets are moving with extreme volatility and counterparties and borrowers may be at heightened risk of default; but these are the very times when the assumptions underpinning the capital models break down most egregiously. Thus, the regulatory capital models truly are classic umbrellas which work only whilst the sun shines, yet the BCBS persists in using these flawed models.

It’s worth remembering how the economist Frank Knight described the difference between “risk” and “uncertainty”: risk is the potential for adverse outcomes drawn from a distribution which is known, whilst uncertainty is the potential for adverse outcomes drawn from a distribution which is not known, the latter being what Nassim Nicholas Taleb refers to as “Black Swan” events.

In using historical observations to inform their view of potential adverse future outcomes, risk managers treat financial risks as “risks” (in a Knightian sense), in that they treat them as adverse events drawn from a known distribution. Risk managers do this because it is the only way to make risk quantification tractable. The truth, however, is that due to the CAS nature of markets the future is fundamentally unknowable, and in reality what risk managers are dealing with is uncertainty. As risk managers, we are like the man who is looking for his lost key under a street light on a dark night. He is joined in the hunt by a friend, who, after some time of fruitless searching, asks: “Are you sure this is where you lost your key?”, to which the man replies: “Oh no, I lost it over there!” “Well”, his friend says, “if you know you lost it over there, then why are you looking here?”, to which the man replies: “Because this is the only place where I can see!” We call ourselves “risk managers” and treat the uncertainties we are dealing with as risks, because doing so gives us access to the only tools we have, and although they are not the right tools, they are better than nothing.

Closing Thoughts

Does all this mean that I have turned my back on risk management and the tools I used and helped develop during my career? Absolutely not! Whilst I don’t believe that statistical metrics such as VaR and ES are appropriate for determining capital underpinning, nevertheless they should be a part of the risk manager’s armory. For one thing, actual stress events are mercifully rare, and so although scenario analysis may be a better tool for determining minimum bank capital, we rarely get the opportunity to test those models. But if we use the same P&L representation (which tells us how the value of a position changes with changes in the underlying market levels) and risk representation (which we use to express changes in the market risk factors feeding into the P&L representation) to calculate VaR/ES as we use to perform scenario analysis, then VaR/ES give us a relatively high-frequency measure of the adequacy of our P&L and risk representations through the daily performance of granular P&L predict-and-explain and granular back-testing.

The facts that markets are CAS and that what we as risk managers are really dealing with is uncertainty is why there can never be a silver bullet for risk quantification. And that is why, as a physicist and a risk manager for more than thirty years, I believe that, for all the developments in quantitative risk metrics and the formalization of risk management during the course of my career, risk management will forever remain as much an art as it is a science.

Steve Lindo

author

Paul Shotton

Paul Shotton is a physics PhD with more than 30 years of practice in financial market risk analytics and executive leadership. His current roles include CEO of Tachyon Aerospace, an aerospace technology company, and chairman and CEO of White Diamond Risk Advisory, which advises CEOs, boards and startup companies in the finance and technology sectors. Paul developed his knowledge of markets and honed his insights in high-level trading and risk management positions at financial institutions in major metropolitan hubs, first in fixed-income trading positions at Goldman Sachs and Deutsche Bank in London, and subsequently, in New York, as global head of market risk management at Lehman Brothers and deputy head of group risk control and methodology at UBS. Paul is a frequent publisher of articles on economics, corporate governance and risk management.

Synopsis

FTX’s unravelling and ongoing bankruptcy proceedings have led to the uncovering of potentially criminal self-dealing, regulatory laxity and misplaced optimism in crypto to self-regulate. As risk professionals, now is an opportunity to step back, observe historical precedence and notice where regulation (already in place for banks) may have made the difference. In doing so, both crypto’s risks and the likely path of future rules are made clearer.

the FTX

Implosion

by Dan diBartolomeo

The bankruptcy of FTX, a large international cryptocurrency dealer, will no doubt have serious repercussions in the cryptocurrency world. The investigation into what went on at FTX could take months or years to be completed. Since the major business unit was legally located in the Bahamas, known for accommodative regulations and incentives for foreign businesses, there are probably few regulations that could be broken. Most regulations that do exist relate to privacy of financial transactions which will slow down any judicial proceeding. There were obviously some rules in place as FTX continues to allow withdrawals from accounts of Bahamian citizens while non-local accounts have been frozen. This kind of “don’t mess with the locals” rule is common in tax havens like the Cayman Islands, Panama, etc. Financial firms in these jurisdictions have an expectation of criminal charges for fraud if local citizens lost out, while prosecution for losses suffered by external participants is extremely rare. Mr. Sam Bankman-Fried, CEO of FTX has been criminally charged in the United States with various fraud charges. The legal process of extradition is moving forward at this time.

FTX’s makeup and regulation

FTX was organized with three key corporate units (and numerous subsidiaries), one of which, Alameda, undertook proprietary trading with the firm’s capital. The main business was the crypto equivalent of a securities broker-dealer, but broker-dealers are heavily regulated in the US under the Securities Act of 1934, Rule 15c3-1, known as the “net capital rule.” All the technicalities around this rule run to about 300 pages. Most other countries with organized financial markets have similar rules. If FTX had been regulated as a broker-dealer, then all customer funds and assets for which the investor had fully paid would have to be kept segregated from any funds available to the firm. If a customer has a margin account with a broker, then assets of the margin account act as collateral for loans from the broker to the customer.

The broker can then pledge those same assets for loans to the broker from an external lender (e.g. a bank). The net capital rule regulates how these collateral relationships are managed and how much firm capital and liquidity the broker must maintain.

If crypto was regulated as a commodity (as the US IRS treats it for tax purposes), then FTX would have been treated as a “futures commission merchant”, or FCM, by the CFTC. FCMs are subject to a similar net capital rule, CFTC 1.17(a)1(i), which requires net capital of $1 million or more based on the volume of business. If the FCM deals in over the counter (OTC) transactions, the minimum capital is $20 million.1 Given FTX’s “total assets” of tens of billions, the capital requirement would obviously have been substantial.

what happened at FTX?

From early reports, it appears that FTX lent $10 billion of customer funds/assets to their own trading affiliate (Alameda) without collateral. Initial reports suggest that around $1.7 billion is now missing, most probably through trading losses at Alameda. There have also been news reports of a separate $473 million in suspicious transactions that could represent further losses. Some industry sources have speculated that these transactions were related to the aforementioned actions of Bahamian regulators to mitigate risk to local citizens. It should be noted that most trading in fiat currencies (FX) and physical commodities (e.g. gold bars) is also unregulated in the US and many large countries. However, most currency trading is done by banks, so the activity is often indirectly regulated.

Near the end of November, US-based cryptocurrency lender BlockFI declared bankruptcy,`1 citing exposure to the FTX implosion. Interestingly, BlockFI named FTX affiliate Alameda as an entity to which it lent while also citing another FTX unit as a creditor. While such “both way” counterparty risk situations are common among financial institutions, it also raises the possibility that FTX was using outside firms such as BlockFI as a conduit to disguise movements of funds among FTX units. The extent of further fallout in terms of contagion effects from the FTX collapse is currently unknown.

investor risks in wake of FTX’s implosion

From a theoretical perspective, investors are dealing with both market risk and operational risk, being jointly important but hard to assess. Our research article published in the Global Commodities Applied Research Digest (JPMorgan/University of Colorado) provides a unique framework for that problem.2 A less formal version of the same article appeared in PRMIA Intelligent Risk’s November 2022 edition. Northfield’s Peter Horne has also published two related articles in the Journal of Performance Measurement on how the evolution of cryptocurrencies and “decentralized finance” will impact institutional investors. At least one institutional investor, the Ontario Teacher’s Pension Fund, has indicated investments of about CAD $95 million related to FTX.