Positive & Negative Feedback Loops in Financial Markets (Examples)(Systemic Risk)

Positive and negative feedback loops in financial markets are concepts that can contribute to systemic risk.

They can lead to market volatility and even crises in extreme circumstances.

These loops are mechanisms through which the dynamics of financial markets can either self-reinforce (positive feedback) or self-correct (negative feedback).

 


Key Takeaways – Positive & Negative Feedback Loops in Financial Markets

  • Positive Feedback Loops Amplify Movements
    • Example: Margin calls during market downturns force selling, driving prices lower and triggering more margin calls, reinforcing downward price falls.
  • Negative Feedback Loops Stabilize Markets
    • Example #1: Central bank interventions (e.g., rate adjustments) in response to growth/inflation/financial stability conditions can dampen volatility and restore equilibrium.
    • Example #2: Fiscal policy might also be loose during weak economic conditions to fill in the gap from the contraction in private credit creation and be tighter when the economy is better and less stimulus is needed.
  • Systemic Risk Awareness
    • Both loop types can precipitate systemic risk, underscoring the need for careful monitoring and management of market dynamics.

 

Positive Feedback Loops

Trend Following

This occurs when traders/investors buy assets because their prices are rising and sell them because they are falling.

This reinforces the initial price movement.

For example, during a bull market, rising prices attract more buyers, driving prices even higher.

Retail traders/investors tend to be more momentum-driven as a whole.

Margin Calls and Leverage

When markets decline, leveraged traders/investors might face margin calls, forcing them to sell assets to raise cash.

This selling can drive prices lower, triggering more margin calls and further downward movement in prices.

Herding Behavior

Market participants often mimic the strategies of others (herding) – especially in uncertain environments.

Even automated strategies tend to widen their bid-ask spreads in more volatile conditions.

If many traders/investors follow the same strategy, such as all trying to exit a position/market simultaneously, it can significantly amplify market moves.

 

Negative Feedback Loops

Mean Reversion in Valuations

Over time, some asset prices tend to revert to their historical averages.

When prices deviate significantly from intrinsic values, they may eventually self-correct, creating a negative feedback loop.

Commodity prices are known for this (over the long run), with a long cycle around this (adjusted for inflation).

For instance, if stocks become overvalued and out of line with their fundamentals, they might eventually see a price correction.

Automatic Stabilizers in Economics

In economics, automatic stabilizers like unemployment benefits increase spending during downturns and decrease it during upturns, helping to moderate economic cycles.

Central Bank Interventions

Central banks often act as negative feedback agents by changing monetary policy in response to economic conditions.

For instance, raising interest rates to bring down private sector credit creation to lower inflation, or lowering them to do the opposite for a struggling economy.

 

Systemic Risk Implications

Positive Feedback Loops

Positive feedback loops can contribute to systemic risk by amplifying market trends, which can include bubbles or crashes.

They often lead to a build-up of imbalances in the financial system, increasing the risk of a major correction or a financial crisis.

Negative Feedback Loops

Negative feedback loops, on the other hand, tend to mitigate systemic risk by counteracting excessive movements in financial markets and helping to stabilize the economy.

Nevertheless, if these mechanisms are weak or delayed, they may not be sufficient to prevent or contain a crisis.

 

Conclusion

Understanding these feedback loops is important in financial risk management, as they can have significant implications for market stability and investor behavior.