THE DANGER TO THE SYSTEM IS THE SYSTEM
As experience has shown, the problems that lead to crisis emerge from within the market. In the case of the Internet market bubble, it was the coalescence of trading views, leading all those remaining in the market to bid against one another, encouraged at each turn by the increases in prices that were nothing other than their own doing. In the LTCM meltdown, it was the liquidation forced by the creditors, which led prices to drop, causing the successive liquidations that pushed creditors to take even more draconian actions. In the 1987 crash, it was the hedging actions that led to the price declines, which, through the non linearity of the strategies, led to even more aggressive hedging.
We can react to opportunities only based on the knowledge that we have. We can manage risks only when we can identify them and ponder their possible outcomes. We can manage market risk because we know securities prices are uncertain; credit risk because we know companies can default; operational risk because we know missteps are possible in settlement and clearing. But despite all those risks we can control, the greatest ones remain beyond our control. These are the risks we do not see, things beyond the veil. The challenge in risk management lies in our ability to deal with these unidentified risks. It is more than a challenge; it is a paradox: How can we manage a risk we do not know exists? The answer is that we cannot do so directly. But we can identify characteristics of risk management that will increase our ability to react to them.