CHICAGO, IL - FEBRUARY 06: Traders signal offers in the S&P options pit at the Cboe Global Markets, Inc. exchange (previously referred to as CBOE Holdings, Inc.) on February 6, 2018 in Chicago, Illinois. Yesterday the S&P 500 and Dow Industrials indices closed down more than 4.0 percent, the biggest single-day percentage drops since August 2011. (Photo by Scott Olson/Getty Images)
As rates rise we will almost certainly see more financial shocks © Getty

As stock markets gyrated wildly earlier this week, the Reddit social media platform delivered a scream of pain from somebody called “Lilkanna”, who claimed to be a small-time investor holding exchange-traded notes that bet on low US equity volatility.

“I started with 50k [dollars] and traded all the way to 4 mill over 2.5 years . . . using more and more margin [ie debt],” this declared. “But now I have lost $4m, three years of work, and other peoples’ money. Really fu**ing stupid. I feel like such a fool.”

Quite so. For months, commentators have warned that a correction in the US stock market was overdue. Financial insiders have also warned that volatility was bound to explode after last year’s supernatural calm, spelling disaster for anybody who — like “Lilkanna” — held ETNs that bet on low volatility.

But this week’s gyrations nevertheless came as a shock. And while nobody knows whether Lilkanna really exists, since Reddit is anonymous, the post exemplifies a bigger point: though markets have since stabilised, this week’s correction is a potent warning sign of bigger risks that lie ahead.

The financial world faces at least three key issues, with echoes of the past: cheap money has fuelled a rise in leverage; low rates have also fostered financial engineering; and regulators are finding it hard to keep track of the risks, partly because they are so fragmented.

The debt issue is the easiest to understand. When the financial crisis exploded a decade ago, the trigger was excess borrowing among American consumers and financial institutions. Thankfully, this has receded. Western banks and hedge funds have dramatically less leverage than before.

This is important and reassuring. It means the core of the financial system is much healthier. We are unlikely to see a 2008-style crisis where strings of banks topple over.

But this does not mean that debt has disappeared. Far from it. The Bank for International Settlements calculates that global debt to gross domestic product is now 40 per cent higher— yes, higher — today than it was a decade ago. That is partly due to rising government borrowing in the west. Chinese debt has also exploded. But leverage has crept, almost unnoticed, into the corporate world.

Standard and Poor’s, for example, calculates that global non-financial corporate debt grew by 15 percentage points to 96 per cent of GDP in the past six years, with some 37 per cent of companies deemed to be “highly leveraged”, up from 32 per cent in 2007.

And while this is easy to service in a world of low interest rates, central banks are starting to raise rates. Indeed, this week the 10-year treasury yield rose above 2.8 per cent. One way to make sense of this week’s events, then, is that investors are starting to wake up to these issues.

This highlights a second point: financial engineering has proliferated in the low-rate era. A decade ago, investors tried to manufacturer higher returns with products like collateralised debt obligations, or CDOs. This week it was other three-letter acronyms, such as those ETNs, that blew up.

Thankfully, the scale of the exotic products creating havoc this week is a mere $6bn-$8bn, and they only affect equity markets, not credit channels. But the bigger point is this: in recent years many investors have built their portfolios assuming that rates would stay low. It will not be easy to unwind this calmly.

To make matters worse, the structure of markets is changing due to a digital revolution. JPMorgan estimates that today a mere 10 per cent of equity trading is being conducted in the old-fashioned way, by discretionary human traders; the rest is mediated by computer programs.

This appears to have contributed to the wild market swings we saw last week. It also creates a practical problem for regulators: the officials (and investors) who understand cyber issues tend to sit in different departments from those who study finance.

The good news is that these issues will not necessarily spark a full-blown crisis — at least not anytime soon. The core of the financial system is much healthier than before, regulators are (a little) wiser, the global economy is still growing and many investors remain flush with cash.

But the crucial point to understand is that as rates rise we will almost certainly see more financial shocks. So scoff, if you like, at Lilkanna’s folly. But his or her bad bet was merely an extreme version of the game that many investors have played in a world of cheap money and rising debt. Ignore that at your peril.

gillian.tett@ft.com

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