Acting OCC chief points to ‘tail risks’ from Ukraine invasion, crypto

The impacts of Russia’s invasion of Ukraine, as well as crypto-related derivatives trading, on financial industry “tail risks” – low-probability, high-impact risk events – were the focus of remarks delivered Thursday by the national bank regulator during a banking industry risk conference.

In his remarks, Acting Comptroller of the Currency Michael J. Hsu looked at the ways these two events are affecting the way financial institution risk managers must evaluate and manage risk across the enterprise.

Hsu, acting head of the Office of the Comptroller of the Currency (OCC), said the most direct impact of Russia’s invasion on Ukraine is the heightened geopolitical risk of broader conflict in Europe. Such broadening, he said, could have significant effects on regional economies and financial markets. Heightened cyber risk and inflation risk are also in the mix, he noted.

As for trading in crypto derivatives, Hsu ticked off several tail risks that he said banks should consider before proceeding too far into that market:

  • Limited or unreliable price histories for crypto-assets. Most risk models rely on robust price histories to inform risk metrics, which are used as inputs to calculate capital requirements. “Underappreciation of the limits of today’s price histories for crypto-assets can lead to underestimation of the actual and tail risks of crypto-related positions, which could translate into undercapitalization of exposures,“ he said.
  • Certain crypto positions being netted in the risk aggregation process for risk reporting, regulatory capital, and risk management purposes is a concern, in his view. “While the management of basis risk is a bread-and-butter skill for derivatives traders, history is littered with examples of supposedly hedged positions blowing up: Long-Term Capital Management, Amaranth Advisors, statistical arbitrage funds in August 2007, and the London Whale, to name a few,” he said. “In each case, the net risk positions prior to the blow-ups were reported as hedged and thus manageable, which dulled risk signals and allowed portfolios to grow to dangerous sizes.”
  • The potential for wrong-way risk may be heightened with crypto derivatives. “For counterparties that are structurally long crypto and use such trades to double-down to get further leverage, the amount owed by that counterparty to the dealer bank would increase at the same time that the counterparty would be experiencing financial stress,” he said.