James Aitken – Systemic Risk in a Crisis (Capital Allocators, EP.126)

Market Turmoil

The recent market turmoil has been marked by rapid and violent movements across equities and credit. James Aitken explains that this is partly due to the constrained balance sheets of primary dealers and large banks, which limit their ability to intermediate in volatile markets 1. The simultaneous supply shocks from Covid-19 and geopolitical tensions have further exacerbated these dynamics, leading to unpredictable shifts in correlations and volatility 2. Aitken notes, "The enormous leverage and frankly, the enormous losses that have been sustained during this period, and the Koolaid financial history will judge them."

The enormous leverage and frankly, the enormous losses that have been sustained during this period, and the Koolaid financial history will judge them.

--- James Aitken

These factors have created a precarious environment where traditional strategies based on stable correlations and volatility are being tested.

   

Volatility Strategies

Volatility scaling strategies have played a significant role in recent market disruptions. James Aitken highlights how these strategies, which involve adjusting exposure based on changes in implied volatility, have contributed to instability 3. As volatility decreases, investors increase their exposure, and when it spikes, they rush to hedge, often too late. This behavior has led to a "slower fool theory," where everyone believes they can exit positions faster than others. Aitken reflects on this fallacy, stating, "It's perfectly okay to own all the same instruments as everyone else... But don't worry, I'll be quicker than everyone else to get out."

It's perfectly okay to own all the same instruments as everyone else... But don't worry, I'll be quicker than everyone else to get out.

--- James Aitken

This approach has amplified market swings, as many investors simultaneously attempt to adjust their positions.

   

Treasury Challenges

The treasury market has faced significant challenges amid recent volatility. James Aitken discusses how the Federal Reserve and other central banks have stepped in with open-ended asset purchases to ensure market functionality 4. The dislocation in the treasury curve, exacerbated by the Fed's unexpected rate cut, has led to a massive unwinding of relative value trades and risk parity strategies 5. Aitken describes the situation, "The irony is that the Fed cutting triggered a run on financing of a lot of these rv guys, which then forced them all to de lever."

The irony is that the Fed cutting triggered a run on financing of a lot of these rv guys, which then forced them all to de lever.

--- James Aitken

This has resulted in significant "indigestion" across primary dealer balance sheets, further complicating the market landscape.