In 1998, the European Central Bank (ECB) was established as the common central bank for the countries in the euro area by the Treaty of Amsterdam. The ECB’s primary objective is to maintain price stability – a responsibility that was transferred from the individual countries’ central banks to the ECB. Nowadays, the euro area’s national central banks function as independent public bodies within the European System of Central Banks, each with their own national duties and mandates.

Here in the Netherlands, one of the duties of DNB is to safeguard the stability of the financial system. As part of this duty, DNB aims to combat systemic risk. To this end, DNB monitors developments in the financial sector, and presents its findings in periodical reports such as the semi-annual Financial Stability Report (most recent edition: June 2018), which includes an overview of systemic risks. In a recent study into proportional and effective supervision, published in May 2018, DNB warns specifically of increasing systemic risks as a result of decreasing diversity.

At Transtrend, we share these concerns; this topic has been high on our agenda for a long time already, all the more so since the onset of the Credit Crisis. In spring 2009, we presented our views on this matter in an essay which continues to be relevant today. In our policy on responsible investing, we also draw attention to this topic. We wish to contribute to well-functioning, well-organized, and reliable markets, and we take care not to get carried away in uncoordinated cooperation. A healthy market requires a sufficient number of participants with different points of view, different interests, and different goals, deploying different strategies at different times.

A lack of diversity is the single most important cause of systemic risk. We highlight the following sources of systemic risk:

1. Standard VaR models

It has become standard practice for many financial institutions and fund managers to use Value-at-Risk (VaR) models, not only to measure risk, but also to control risk. In many cases, risk management policies contain elements of keeping the outcomes of these VaR models within certain strict limits. Our concern is that many parties use very similar standard models, which have a number of disadvantages, most notably a tendency to overreact to large market corrections. As a consequence, parties that use these models will be forced to decrease their positions at times when market stability would be better served if they did not. What is more, they will decrease positions more or less simultaneously – that’s where the systemic risk comes in. This same issue is raised by DNB in its observation that market corrections may force funds to liquidate positions, which would further amplify the correction.

2. Passive investment strategies

The shift towards more passive investment management is another development that DNB identifies as a source of systemic risk. One of the characteristics of these ‘passive’ investment strategies is that capital flows in individual instruments – such as Unilever stock, or cocoa futures – are mostly driven by global developments, not by developments relating to the particular instruments themselves. The biggest problem here is that often, the liquidity of such individual investments does not match the liquidity offered by the passive investment funds. As DNB describes, this may lead to self-reinforcing effects in markets on account of investors withdrawing from these funds.

3. Standard execution algorithms

In electronic markets, orders can only be executed by means of execution algorithms. Many parties choose to use the – often run-of-the-mill – algorithms that their brokers provide. Should a hundred different market participants, with different perceptions, different interests, and different goals, on any day decide that today is a good day to buy market X, and each one deploys a similar execution algorithm, it will be as if they are acting in concert – all working a single, large order in market X. Compounding the problem is the fact that the most commonly used algorithms are price-insensitive, which means that they will continue to sell in a falling market, as they infamously did during the 2010 Flash Crash.

4. Concentration of Central Counterparties (CCPs)

CCPs play an increasingly important role in the infrastructure of financial markets. In the past, they proved their value in times of crisis. Engaging a CCP helps to decrease both counterparty and operational risks, two advantages that we have indeed experienced in our own history of trading futures markets. Some of these CCPs, however, through mergers, acquisitions, and other means, have grown so big that they themselves may have become a concentration risk. DNB also recognizes this systemic risk.

5. Undue stringency in regulation

Although traditionally the approach in Europe has been to develop principles-based regulation, in recent years there appears to be a shift towards rules-based regulation. The main difference between the two approaches is that rules-based regulation will be detailed and specific, while principles-based regulation will avoid rules in favor of general guidelines. An advantage of rules-based regulation is that implementation can be checked relatively easily. A disadvantage is that it offers market participants less flexibility in implementing solutions that best suit their particular situation. As DNB itself realizes, the unintended consequence of this shift has been a loss of valuable diversity. In the words of Jan Sijbrands, outgoing director at DNB, “As rules are tightened, financial institutions become more and more alike.” Or, in our words, regulation that is unduly stringent will direct uncoordinated cooperation.

6. An auditor’s preference for checking the box

When the Credit Crisis started, it appeared that rating agencies had been a source of systemic risk. The problem did not lie in the quality of their ratings, but rather in the fact that so many parties relied so heavily on them. Auditors had played an important role in this proliferation, by rapping parties on the knuckles for choosing not to rely on these ‘independent’ ratings. Unfortunately, this mindset still seems to be prevalent among auditors. Where regulators do leave room for made-to-measure tailoring, some auditors will nevertheless set store by using a standard, one-size-fits-all approach. Where the rules are not specified in great detail, some auditors insist that industry best practices be followed. As a consequence, they limit themselves to assessing whether or not such best practices are adhered to, and checking the box accordingly. Taking a made-to-measure approach seems to be called into question (comply or explain), while the prevention of systemic risk would be better served if those who take the standard approach would be required to motivate their choice instead (explain why you comply).

Well-functioning markets need rules and regulations that are effective. And whoever is active in the financial sector must be accountable for their behavior. This accountability, however, will not serve its purpose if it is merely a check-the-box exercise dictated by fixed rules. Fixed rules will leave a system rigid and inflexible, while a strong financial system requires some degree of flexibility. What cannot bend will break.