SNB: Restoring Price to the Market

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Gregory Marks's picture

On January 15th, 2015, we witnessed a 15 standard deviation event in the EURCHF* and USDCHF market. For those unfamiliar with such terminology, a 15 standard deviation event would be unlikely to occur in your lifetime. It is not to say it is impossible, but on a relative basis it's pretty impossible, especially when putting it in the context of the most liquid market in the world: foreign exchange. 

What is the likelihood of a 15 standard deviation event? Here you go:

So the probability of occurrence is roughly 1 in (1.36*(10^50)), also equal to 1 over Bremermann's Limit (the minimum size of encryption keys that would be needed in order to create an algorithm that could never be theoretically solved). In the world of risk management, a statistical model would suggest you worry more about getting struck by lightening or asteroids than a 15 standard deviation event, so feel free to bet the farm. It may seem silly to think about recent foreign exchange price action this way, but here we are just giving a voice to the models that run portfolios and risk management around the globe. This sort of logic is now embedded as a fundamental foundation of financial markets.

It would seem as though we could characterize this event as unnatural in a number of ways. Unnatural in its occurrence, but more importantly unnatural in its root cause. After all, over the last few years the Swiss National Bank has been playing God with prices in order to control flows and volatility in the CHF market.

Years of this sort of intervention conditions market participants and models into discounting impossible events. Another example of this conditioning can be found in the run-up to 2008, where policy promoting ever increasing home prices led to VaR models that never considered falling prices. With current monetary policy around the world out to suppress volatility and support asset prices, what sort of conditioning is occurring under the surface?** As my former colleague, Kristian Kerr, at DailyFX asks, is the true ‘bubble’ out there simply in the belief that central banks have everything under control?

I would tip my hat to the SNB for restoring 'the market' to the Franc if it weren’t for the fact that this action was taken most likely to facilitate manipulation by the European Central Bank in the EU bond and Euro market.

By no means am I a believer in efficient market theory. Our emotions, human psychology, group think, these things all stand in the way of unbiased and true pricing. Equilibrium is arbitrary, but I nevertheless remain confident that markets do a better job in pricing than any other alternative.

At the same time, when prices and volatility are controlled or guided by monetary authorities with (what appears to be) unlimited reach, all that is bought is time. History has shown us that volatility and the natural cycle of prices can never be dismissed, only mitigated in the short run, packaged and shipped to a later date. 

Of course there will be some economists who say this move was out of weakness, but may I remind them of the prerequisite that is an assumption in their models: a free market. Returning price to the market is a noble endeavor; it should have never been taken away. 

*(I have heard some dealing in the interbank market was as low as the mid 60s. This would have been a 21 standard deviation event.) 

**(Shiller on the decades that equity prices did not rise in real terms.)