(Bloomberg) -- The Bank for International Settlements is warning the financial system is prone to repeat episodes of volatility like the one that rippled across markets this summer when a popular hedge fund strategy collapsed.
As central banks across the world withdraw liquidity, investors will be forced to reduce leverage and review risk strategies, the BIS said in a report published on Monday. The unwinding of so-called carry trades is the most recent example of the potential consequences of that transition.
“We should be under no illusion. This is not the first and will not be the last turbulence in markets,” said Claudio Borio, head of the monetary and economics department at the BIS, in a press conference. “It is part of the bigger picture, the inevitable withdrawal symptoms that markets suffer as they transition away from the extraordinary period of exceptionally low interest rates and ample liquidity.”
Traders who had borrowed heavily in yen and parked the cash in higher-yielding assets were forced to rapidly unwind their positions as the Bank of Japan raised interest rates in July. The violent moves spilled over into other assets and raised alarms about how much leverage had built up in the financial system, leaving traders guessing whether there’s more to come.
The BIS said it’s looking to improve how it tracks carry trades to get a better reading of market vulnerabilities. Information on foreign-exchange derivatives including forwards, swaps and options, currently lacks clarity on the specific purpose of each trade, and the BIS is working with its member central banks to collect additional data on the transactions.
Part of the current challenge is that investors commonly use FX derivatives both for speculative carry trades as well as for hedging and liquidity management purposes, making it difficult to size up overall activity.
In its report, the BIS said carry trade strategies were crowded and highly leveraged in the run up to the August blowup. As the incentive to partake in carry trading strategies remains, policymakers need to closely monitor developments, the BIS said.
“We need to have a very keen eye on the potential risks that are building up,” said Hyun Song Shin, economic advisor and head of research at the BIS, in a press conference. “Financial conditions are really key for the conduct of monetary policy, this is of first order importance for central banks.”
©2024 Bloomberg L.P.
