The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis

Financial systems in which many participants rely predominantly on leverage and carry rather than the quality of the assets to reach their return goals are unstable since small losses can trigger widespread insolvencies.

Winter 2021 • Cato Journal
By Allan M. Malz

Over the past quarter‐​century or so, the United States and the world have experienced a relatively new and puzzling, yet old and well‐​understood, phenomenon. Generally, accommodative monetary policies by major central banks have been punctuated by financial crises large and small rather than by spasms of inflation. The era has been characterized by declining productivity, growth and overall economic vibrancy in spite of an explosion of new ideas and technologies. The Rise of Carry looks at the financial mechanisms underpinning these maladies from a new and unusual angle. It identifies at their core an approach to trading heavily reliant on leverage, the use of borrowed funds. Public policy, particularly monetary, encourages leverage and enables it to become excessive, undermining financial stability and ultimately leading to a decline in financial stability and economic dynamism.

The book’s new angle is from the point of view of the carry trade, a trading strategy that serves as a technical description and a metaphor for the incentive system built by the policy prescriptions that keep the financial system leveraged and fragile. The term “carry trade” was originally applied to a set of foreign exchange transactions in which a sum is obtained, largely by borrowing, in a currency with low money market interest rates, and exchanged for one in which rates are materially higher. If the purchased higher‐​rate currency appreciates, or at least doesn’t depreciate too much and too fast against the borrowed currency, the trader stands to net some interest income. The difference between the cost of funds and the interest on the purchased currency is called the “carry,” and capturing that gap is the primary aim of the trade. Credit expansion is fostered in the countries issuing both the funding and purchased currencies.

Three features are emblematic of this trading strategy. First, if the carry‐​trade transactions are not hedging an existing offsetting foreign exchange exposure, then it is an outright bet the purchased currency will retain or even gain in value. Typically, that purchased currency is that of an emerging‐​markets or export‐​dependent economy susceptible to infrequent but sharp and sudden depreciations. Second, it can be executed primarily with money borrowed in the low‐​rate currency from a bank or dealer. At the extreme—to which the reality at times comes remarkably close—in which the entire sum borrowed is owed to a bank or dealer, and the trader has invested no funds of her own, the trade is infinitely leveraged. If it goes well, her rate of return on equity is infinite, and if it’s a loser, she can walk away with at most reputational damage.

Finally, like any other credit transaction, it is in essence also a financial option trading strategy, with several possible framings for analysis. It can be viewed as a long, or purchased, option position, with no inherent limit on the profit of the trader if the trade goes well. Her potential loss is capped at the cost of the option, equal to the amount of her own equity in the trade. The lender, the bank or dealer financing the trade, is in the position of the option seller, with limited profit but exposed to the loss of the entire sum lent.

But the authors set out another, more refined framing of the option‐​like character of the carry trade. The inherent instability of the carry regime can be most clearly seen through its close kinship with market making in options. As the authors explain, option values can be roughly replicated by “trading with the market,” buying the underlying asset when its price rises and selling when its price falls. Option values are therefore higher when asset prices are moving around a lot and this pattern of trading with the market becomes more costly, that is, when volatility is high.

Selling options and protecting one’s position by replicating the options in the underlying asset market is generally profitable, because the demand by many investors for protection from market fluctuations keeps the expected or implied volatility embedded in the options’ market prices higher than the actual volatility driving the cost of replication. The market maker in options collects an insurance or risk premium for offering protection through options.

Carry as metaphor unlocks much insight into contemporary finance. Although the assets they invest in are very different, many widely employed trading and investment strategies are similar in structure to those involved more transparently in the original foreign‐​exchange focused carry trade. For example, like that of the original carry trade, much of the financing of hedge funds and private equity—the key components of the “alternative asset” universe—is provided by banks, securities dealers, and other money market lenders at short term, or in the form of leveraged loans, typically issued with longer terms to maturity but with floating interest rates. The borrowing is collateralized by the assets acquired, like the purchased currency in the original carry trade, and the ultimate creditors also include insurers, pension funds, and mutual funds.

These assets differ vastly from one another, ranging from government bonds to ownership stakes in small, troubled, or undervalued companies, but the type of funding is similar. The “carry regime,” as the authors term it, depends on funding liquidity, that is, the ability to readily finance asset positions predominantly with borrowed rather than own funds. Profitability and even investors’ solvency are highly vulnerable to an abrupt retreat from short‐​term lending or rise in money‐​market rates, and to a decline in the funded assets’ values. The ultimate providers of this liquidity are central banks and regulators. They provide liquidity in two distinct ways, through monetary policy, but also through their explicit and implicit guarantees of the liabilities of the key lenders—the banks, dealers, and institutional investors.

Similarly to option selling, carry trades rely on a persistent gap between the market values and likely realized future values of assets that are risky and distasteful to hold—an emerging‐​markets currency, a long‐​term credit‐​risky bond, a troubled firm’s shares—because they are susceptible to sudden large drops in value or tend to drop in value and become hard to sell in troubled times. Just as for option selling, the result is a pattern of small gains punctuated by ­sporadic large losses. Carry trades are rewarded for the liquidity and the insurance against adverse changes in price or credit quality they provide to the market, liquidity and insurance that are ultimately provided and backstopped by central banks and governments.

Financial systems in which many participants rely predominantly on leverage and carry rather than the quality of the assets to reach their return goals are unstable since small losses can trigger widespread insolvencies. As the authors write, “[t]he instability of levered trades is the key reason that carry trades eventually crash.” As more funding is drawn into the business of providing liquidity and protection from price fluctuations, the risk premiums with which these services are rewarded decline, liquidity becomes more robust, and volatility is dampened.

Leveraged trades thrive on high volatility and at the same time suppress volatility, generating a self‐​perpetuating and self‐​amplifying mechanism, a phenomenon known as the paradox of volatility. As researchers at the Bank for International Settlements have also emphasized, volatility and risk premiums are low, asset prices are highest, and the world appears safest, just when leveraged trading is most prevalent, the degree of leverage is highest, and the trading and investment volumes are greatest.

The Rise of Carry lays out these mechanics clearly and connects them to their primary sources. The mechanism relies on incentives. Both the traders’ and the financiers’ incentives are asymmetrical, lopsided, with very large returns in one direction for asset prices and limited returns in the other. But if the potentially unlimited losses of the financier—bank, dealer, or institutional investor—can also be capped by recourse to the government or a lender of last resort, you get the system we are living in today.

Although it might appear on the surface that this pattern must lead to inflation, as the authors point out, it is in fact deflationary and a drag on real growth. The pattern of expansions characterized by increased leverage is interrupted by regular financial crises large and small. These are countered by further accommodation. Even if central banks tighten credit conditions once leverage has become alarming, they will surely loosen in response to the crackup.

The result is a long‐​term pattern of misallocation of resources and survival of zombie firms kept alive by low interest rates that could not thrive in a normal interest rate environment. Highly leveraged firms may become reluctant to engage in promising new activity since the returns would flow to their creditors rather than owners. As the authors state, “central bank interventions together with excessive government involvement in economies … have resulted in economies with too little savings, too much debt‐​financed consumption, and low prospective returns on real investment.” The Rise of Carry is a valuable new perspective on this old problem and recommended reading for anyone seeking a deeper understanding and timely reminder of this important and disturbing phenomenon.

About the Author
Allan M. Malz