Basis traders, prime brokers and election risk

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The cash/futures basis trade could be a test case for regulating systemically risky activities

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COMMENTARY: Political uncertainty

Risk.net looked this week at the impending US elections and their possible impact on financial markets. The results form a perfect illustration of the distinction between risk and uncertainty. At the moment, Democratic challenger Joe Biden is polling comfortably ahead of President Trump, and the analysts at polling site FiveThirtyEight.com give him an 88% chance of winning. With the election just days away, FX markets are calming in response.

But there’s good reason to think this is too complacent. And here we get into the area of uncertainty – while the polls are an indicator of the likelihood of a Biden victory, there’s no similarly convenient indicator of the chance of a contested election. And here is where the fear really resides. A Risk.net scenario generation exercise explored just how bad things could get: the dollar collapsing against the euro, bond yields and equity indexes plummeting, higher unemployment and the potential for months of uncertainty.

The most recent dubious election in the US was only 20 years ago – in 2000, weeks of recounting and legal argument led to a hair’s-breadth victory by George Bush over Al Gore. Gore’s eventual concession meant that the inauguration was met only with protests on the streets of Washington. The scenario to be feared is that a defeated Trump may not concede, and that a prolonged legal battle may lead to deadlock and dispute in the courts and Congress, and even to violence outside them.

Win or lose, Donald Trump will remain president until his term expires in late January 2021. And if he loses, his actions during this ‘lame duck’ period could be even less predictable than his actions during his presidency so far. Lame-duck presidents have launched foreign military operations (Somalia, 1992), pardoned controversial criminals such as the Iran-Contra conspirators, signed off on huge volumes of regulation and even appointed judges. Under the lame-duck Buchanan presidency, in response to the election of Abraham Lincoln in 1860, seven states declared secession, sparking the US Civil War. The tail risk here goes a long way out.

Could he, theoretically, cause turmoil? Unquestionably. Will he? There’s no way to model this kind of scenario robustly; as in so many areas, in particular in operational and political risk, the actions of risk managers will have to follow not their models but their instincts and judgement. Best of luck.

STAT OF THE WEEK

Första AP-fonden (AP1), Sweden’s state pension fund, has reduced its return expectations to 3% for the coming 10 years – and accepted the fact that bond yields have collapsed. The fund’s chief investment officer feels sorry for US pension funds that still have to generate 8–9% nominal returns.

QUOTE OF THE WEEK

“All of the changes over the last decade – the capital requirements, liquidity requirements, stress-testing, risk management overhauls – have stood the financial system in good stead for dealing with the Covid-19 fallout. But they still didn’t deal with the liquidity issue” – Ashley Alder, Hong Kong SFC