Stability Is a Policy Construct

Abstract

When volatility compresses, risk rarely disappears. It migrates into structure: leverage, liquidity terms, correlation assumptions, and balance-sheet fragility. The appearance of stability can be the by-product of policy and liquidity engineering — not the absence of exposure.

Stability in modern markets is often interpreted as the absence of risk. In practice, it is frequently the result of policy intervention, liquidity engineering and duration extension.

When volatility compresses, leverage does not disappear. It migrates. The question is where it has moved — and who is now holding it.

1. Volatility is not risk

Volatility is a price statistic. Risk is a funding and structure problem. A portfolio can exhibit low volatility while remaining structurally fragile, particularly where liquidity assumptions are implicit rather than explicit.¹

Claim

The more stability is engineered, the more risk migrates into terms, leverage and correlation.

2. Where the risk tends to migrate

In periods of suppressed volatility, the typical migration paths are predictable:

• Duration extension in search of yield, often through benchmarks rather than explicit conviction.
• Liquidity mismatch, where redemption terms and underlying instruments diverge.
• Hidden leverage, whether embedded in derivatives, financing, or balance sheet structure.
• Correlation complacency, where diversification assumptions are treated as permanent rather than conditional.

3. Second-order effects

The first-order narrative is usually “markets are calm.” The second-order reality is that calm reduces the perceived cost of leverage, which increases structural exposure. The system becomes more sensitive to funding shocks.

Risk is not eliminated. It is displaced.

Implication for allocators

Treat low volatility as a prompt to examine structure. Ask what must remain true for stability to persist: funding conditions, policy posture, collateral haircuts, and the assumed availability of liquidity.

If the portfolio’s resilience depends on these variables remaining benign, the stability is conditional — and the capital is, by definition, at risk.

Footnotes

1. Placeholder reference: replace with a source, paper, or data note. Example: central bank balance sheet expansion, volatility control, or liquidity regime shifts. Back to top