The Financial Butterfly Effect

The Butterfly Effect derives from chaos theory; it holds that a small and seemingly insignificant event has the potential to cause a chain reaction of systemic proportions days or weeks later. The Butterfly Effect extrapolated onto financial markets can illustrate the unpredictable nature of risk and the interconnectivity of the world’s financial system.

Many of the economic crises that occurred throughout human history have originated from these seemingly small and unexpected events. Whilst there is an inevitable re-focusing on risk monitoring and mitigation as well as a flurry of regulation aimed at protecting against the recurrence of economic crises, standards drop after a period of time. The problem with this is that in such an interconnected global financial system, it is becoming ever more difficult to anticipate the new risk gaps that surface and the interlinkages that grow between institutions. Furthermore, the internet and greater computer literacy has rendered cybercrimes a major risk to global financial systems, just as the new Basel III regulations and the US Dodd-Frank Act requiring higher capital requirements could give rise to a high-quality collateral squeeze with US$2 trillion in collateral needed just for the first year of implementation of margin rules under the US Dodd-Frank Act alone. In tandem, the IMF has postulated that sovereign credit rating downgrades will result in a reduction in the supply of collateral by US$9 trillion by 2016.

A Financial World of Chaos

Moreover the world's interconnectivity has meant that an earthquake in Japan in March 2013 caused a 6% drop in the shares of a British luxury fashion brand Burberry. And the recent Arab Spring that swept across Egypt, Syria, Tunisia, Libya and Turkey has prompted the patriarchal Arab royal families to embrace English legal concepts such as trusts as wealth-holding structures in order to protect their assets for the next generation.

One financial butterfly effect 'saga in the making' originates from US farmland. US farmland prices have escalated over the past decade as grain prices increased and the Federal Reserve lowered interest rates to historic lows, making it easier for people and businesses to buy farmland. Yet with world grain prices falling as global output increases, US farmers are now suffering from the temperamental weather, limiting their production and diminishing their global market share. Furthermore, the prospect of the Federal Reserve ending its quantitative easing programme is already pushing up the interest rate. These trends could lead to a reversal in US farmland prices. The US Farm Credit System is a government-sponsored enterprise providing federal guarantees for bad loans – similar to Fannie Mae and Freddie Mac providing guarantees for US house prices which helped fuel the US housing boom. Now here many financial companies have exposure to US farmland and may suffer, as do investors worldwide that have poured billions of dollars into US farmland over the past several years.

Seeing the Risk and Reward

Another recent instance is the mere talk of tapering by the Federal Reserve causing financial stuttering in Asian growth markets, particularly Indonesia, Thailand and India. In India's case, its currency has plummeted to record lows despite the Indian Central Bank's recent imposition of capital controls. Meanwhile, world investors are starting to take funds out of emerging markets that they had put there in their hunt for yield and it is now finding their way into Japan's capital markets. This is strengthening the Yen, a contrast to the purported aims of Abenomics.

The global financial industry will never eliminate all risks from the marketplace, and neither should it. Risk and reward are fundamental to markets and the efficient allocation of capital. Yet, it is undeniable that the industry has to beware that the Financial Butterfly Effect means risks can develop and spread faster than ever before. Therefore, protecting against even seemingly minor risks could lead to safer markets and prevent future economic crises.