Wednesday, December 9, 2015

Hollow Markets.......

Hollow Markets

Whatever shocks emanate from polarized politics, their market impact today is significantly greater than even 10 years ago. That's because we have evolved a profoundly non-robust liquidity provision system, where trading volumes look fine on the surface and appear to function perfectly well in ordinary times, but collapse completely 
under duress. Even in the ordinary times, healthy trading volumes are more appearance than reality, as once you strip out all of the faux trades (HFT machines trading with other HFT machines for rebates, ETF arbitrage, etc.) and positioning trades (algo-driven rebalancing of systematic strategies and portfolio overlays), there's precious little real long term investment happening today.

Here's how we got into this difficult state of affairs:

First, Dodd-Frank regulation makes it prohibitively expensive for bulge bracket bank trading desks to maintain a trading "inventory" of stocks and bonds and directional exposures of any sort for any length of time. Just as Amazon measures itself on the basis of how little inventory it has to maintain for how little a span of time, so do modern trading desks. There is soooo little risk-taking or prop desk trading at the big banks these days, which of course was an explicit goal of Dodd-Frank, but the unintended consequence is that  major trading counter 
parties and liquidity providers have been taken out of the market and when things get tough there are enormous air pockets of illiquidity.

Second, the deregulation and privatization of market exchanges, combined with modern networking technologies, has created an opportunity for technology companies to provide trading liquidity on a purely voluntary basis. To be clear, I'm not suggesting that liquidity was provided on an involuntary basis in the past or that the old-fashioned humans manning the old-fashioned order book at the old-fashioned exchanges were motivated by anything other than greed. But there is a massive and systemically vital difference between the business model and liquidity provision regime (to use a good political science word) of humans operating within a narrowly defined, publicly repeatable game with forced participation and of machines operating within a broadly defined, privately unrepeatable game with unforced participation.

Whatever the root causes, modern market liquidity is only skin deep. And because liquidity is only skin deep, whenever a policy shock hits (say, the Swiss National Bank unpegs the Swiss franc from the euro) or whenever there's a technology "glitch" (say, when a new Sungard program misfires and the VIX can't be priced for 10 minutes) everything falls apart, particularly the models that we commonly use to calculate portfolio risk.

For example, here's a compilation of recent impossible market events across different asset classes and geographies (hat tip to the Barclays derivatives team)... impossible in the sense that, per the Central Tendency on which standard deviation risk modeling is based, these events shouldn't occur together over a million years of market activity, much less the past 4 years.  

  

These market dislocations DID occur, and yet we continue to use the risk models that say these dislocations cannot possibly occur. Huh? 

Any trader or investor who doesn't pay attention to the modern realities of market structure and liquidity provision is not going to remain solvent for much longer.

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