The share prices of not very prominent single stocks rocketed by a couple of thousand % within just a few days. Why is this happening? By now most of us have heard about WallStreetBets, the Reddit group of retail investors that successfully targeted the short positions of hedge funds in bets like GameStop, AMC, Blockbuster or Bed Bath & Beyond. But what are the key questions banks should ask themselves?
Short sellers have been hit significantly, e.g. Melvin Capital incurred losses, according to news portals, of around USD 4.5bn (roughly 50% of its market value) during January. Market participants see it more as a threat rather than an opportunity, and hectically imposed trading stops (like the one by Robinhood) do not build additional trust in the market, either. In the meantime the traders are already looking for further targets elsewhere, such as in the Commodities market where they are driving up the Silver price. The developments are now being widely discussed, and the US House Committee on Financial Services held its first hearing on the topic on 18 February 2021. Some questions are inevitably being asked. What are the main risks banks have to look out for? Is this something that will disappear as quickly as it appeared, or is it here to stay? And what should banks do to stay ahead of the curve?
Key question – what is your risk?
Market risk – For those banks in Switzerland that hold significant trading positions on their own books, this should be a significant concern as unexpected volatility can hit their profit and loss very hard.
Credit risk – Developments can hit in various ways. What is the impact on the collateral value if underlying assets are targeted? How do your advance rates react to an increase in volatility? Do you have vulnerable concentrations in single-stock lending? What if clients and counterparties of yours start to actively ride the wave?
Other risks – How long would it take your organisation and processes to trigger margin calls? How should you inform your clients and counterparties about the changing risk in the current market environment?
Where are the biggest uncertainties?
Since this phenomenon is not expected to disappear any time soon, there is significant uncertainty as regards what action might be taken by market participants and regulators. What are the possible targets for groups of retail investors, and how will this phenomenon evolve? How will regulators and supervisory authorities react? To what extent will the observed behaviour be regarded as market manipulation? Will securities exchanges adapt their margin requirements for specific products or segments? To what extent will banks be held accountable for their clients’ trading losses caused by trading stops or technical issues triggered by unexpected market volumes?
Our point of view – your call to action
There’s no need to be concerned if your existing risk management framework, processes and controls have proven to be effective. However, Board and Management should put the following questions on their agenda to ensure tail risks are managed effectively and potential opportunities are identified:
- What positions and which regions might be most impacted?
- Which part of our business model and client/counterparty structure could be exposed?
- Where are the hidden vulnerabilities in our processes and control environment?
- What does it mean for our clients and what are the opportunities?