The Year of the Black Swan

I?ve just spent the entire morning on the phone, and it?s clear that thousands of individuals, hedge funds and brokers have just been wiped out as a result of The Swiss National Bank?s surprise move to remove its cap against the Euro.

This is a black swan on steroids.

And it hasn?t just been Swiss franc positions that have been bedeviling traders. You can add to the list bonds, energy, and this week, financial stocks as well. All of a sudden, the world seems to have gone mad.

The great flaw in the management of big brokers and hedge funds is that they base their risk models on historic data. It is rare to see a foreign currency move more than 1% against the US dollar in a day. You might see that one-day a year.

Risk models, and margin requirements, are therefore based on this assumption. To bomb proof themselves, margin departments might require clients to post collateral assuming that a 2% or even a 3% move in a currency will happen tomorrow.

Even with an ultra conservative 3% margin requirement, a house would only be protected by a move in the underlying of 33%. Any move greater than that, the customer account is completely wiped out, leaving the broker on the hook for the balance of the loss if they can?t get clients to pony up more money.

Of course, US based brokers can always sue their former clients and get their money back that way. But that is a three-year process. Just ask anyone who went through the whole MF Global disaster.

As a former broker myself, I can tell you that clients wiped out by margin calls have a bad habit of disappearing, changing their names and moving to unpronounceable countries to bury the paper trail, or move beyond the reach of extradition treaties. So good luck with that one.

After speaking to several foreign exchange traders, it seems that the first tick after the SNB?s announcement was up a staggering 40% from the last print. The world had stop loss orders to sell Euros as market, and this was the fill they got.

It gets worse. Some brokers, particularly small, undercapitalized foreign ones, were only demanding 0.5% margin or less. These guys are toast, but it may take weeks to find out exactly who.

The news services this morning are ablaze with such losses. Citibank (C) has admitted to a $150 million hickey. Very conservative Interactive Brokers has fessed up to a $120 million hit. FXCM is thought to be out $225 million. All of a sudden, foreign exchange brokers everywhere are for sale at fire sale prices.

These aren?t just some interesting, entertaining and colorful market anecdotes that I?m providing you. The debacle is so severe that it has cast a black cloud over all asset classes.

You see this in the sharply diminished trading volumes in all instruments, from stocks, to options, to futures contracts and exchange traded funds.

If you have just heard of a colleague or a counterparty who has just gone under, trading any of the recent straight line one way moves, guess what? You don?t go out and bet the ranch.

Your risk appetite has been diminished for weeks, if not months. In fact, you may not want to trade at all. This is not good for markets of any description.

I have been through many of these. The best thing to do is to shrink your book, hedge up what?s left, and put your more aggressive tendencies on hold. You may have noticed that the model portfolio for my Trade Alert service has just done exactly that.

Come back only when it?s safe to play, and the markets gets easy again.

FXF 1-16-15

FXE 1-16-15

EUO 1-16-15

John Thoms - Black SwansWatch Out, They Can Bite