Tail risk - shocks and systemic failure

 

All systemic risks will be tail risks, but all tail risks may not be systemic. There is a sequencing of events before there is a systemic failure, so investors may have some warning albeit the speed to systemic failure may be very quick. 

Can you see it coming? It is unlikely you can predict a tail event but they will usually have specific characteristics. They can be firm-specific or macro in nature, but will have to be a surprise to existing expectations. Tail events will not be a confirmation of existing views. The news event must be strong enough to change consensus judgment and consensus will most likely have large, levered capital positions. An exogenous event can lead to endogenous trading events like the February 2018 volatility debacle. We will note that some tail events cannot be directly associated with specific news event. The October 1987 crash comes to mind. 

What is the speed of failure from a tail event to a systemic risk event? Ex post, there will be clear warning signs that could have been seen, but these will usually not be the focus of the market. There will usually be heightened volatility before a systemic risk shock, but the time to a systemic failure risk can be measured at most in days not weeks. The failure in March 2020 was within days of pandemic news fears albeit pandemic warnings were already building in February. 

How do you protect against systemic risk? Beyond being diversified, the simplest answer is measuring the time to cash liquidation. If you must convert all positions to cash, how long will it take? Can you risk bucket all assets by liquidity? Have you identified safe assets? Where are the exits in case there is a fire? Are their secondary primes, brokers, and liquidity providers that can be called upon in a crisis? Of course, having secondary liquidity providers requires regular usage otherwise they will not take your business when asked. Have all liquidity provider operations been reviewed for crisis conditions? if you don't ask now, you will not get any answers during a systemic failure. 

Central banks and government regulatory may be looking at macro-prudential policies but there are no guarantees that any government can provide appropriate policies at all times. Safety is still the burden of the individual investor.