Systemic risks in the market on the rise, says Iosco economist

Risk-taking activity yet again at near all-time highs and return of complex financial instruments is another troubling sign

Systemic risks could be building up in markets yet again, as the search for yield and the return of leverage and complexity in the financial system has led to risk-taking activity and collateralised debt issuance to hit near all-time highs, says Shane Worner, a senior economist at the International Organization of Securities Commissions (Iosco).

Speaking at the 10th annual FX Week Asia conference in Singapore, Worner warned that excess liquidity in the system caused by central bank easing has distorted market prices and re-introduced leverage and complexity in financial markets, which could potentially lead to a build-up of systemic risks.

He noted that appetite for high-yield and subordinated bonds, contingent convertibles (Cocos) and leveraged loans are near all-time highs, as well as hedge fund leverage and leveraged complex products.

"We have seen an increase in the issuance of collateralised debt, which begs the question what will happen when interest rates rise," he said.

Worner noted that the excess liquidity in the system introduced by quantitative easing measures has not filtered through to non-financial institutions, as bank lending to non-financials has remained flat or even declined.

At the same time, US markets are currently two standard deviations overvalued. Worner added that emerging markets equity prices are below that of developed markets but bond prices are also converging.

"I have never seen market conditions like this before; markets are no longer driven by price but central bank liquidity," he noted.

The US Federal Reserve and the Bank of England both embarked on extensive quantitative easing in the wake of the financial crisis, in the hope that the measures will avoid a liquidity shortage and boost the real economy. Last year, the Fed announced it would start to wind down its programme and tighten monetary conditions as the economy showed signs of improving.

Worner also cautioned that while seen as robust, central clearing counterparties also carried risks due to the inherent pro-cyclicality of margin calls, the widespread use of value-at-risk and varying levels of capitalisation.

This article was originally published in sister title FX Week.