when leverage is used to construct market positions, the forced unwinding of those leveraged positions can significantly amplify the harm financial markets in free fall can do to the real economy. Over the last thirty years, as financial markets have grown in size relative to the size of the real economy, that threat looms larger and larger, so what is to be done, asked Martin Moloney, deputy secretary general of the Financial Stability Board (FSB) in a recent speech.
Among the items emerging out of industry consultation are “particularly pointed” responses on how to measure leverage with questions over use of the gross notional leverage measure because it doesn’t differentiate between hedging and leveraged directional positions.
This, Moloney said, gave him a “strong sense of déjà vu”.
“Some years ago, IOSCO – responding to an FSB recommendation – wanted to develop a way to look for build-ups of leverage. I was involved and we had lengthy discussions on what gross notional data was good for and what it was not good for. Our conclusion rested on a key observation: a hedge only works as long as it works, by which I mean as long as there is the liquidity to finance it.
“Remember our focus is not on leverage, but on deleveraging. And a hedge can unwind under stressed market conditions just like a leveraged directional position. We need to know what is the total amount of leverage in a market to know how much can go wrong.
“My memory is that IOSCO at that time concluded that it needed a two-stage process, stage one: find out what is the total leverage, stage two: understand where the leveraged risk sits. Gross notional was deemed good for the first, but not so useful for the second.
“It seems very likely to me that the FSB will come to a similar conclusion for its purposes as IOSCO came to at that time for statistical purposes. And its easy to illustrate that: ISDA’s own Interest Rate Derivatives Trading Activity report will tell you a total number, lets say, the increase in IRD notional.1 That doesn’t explain to you what is happening in the market, but it allows you to pose an informed and pointed question for further analysis. I expect the Gross Notional measure of leverage will have a similar role in our work on leverage.”