Collateral

I apologize.

Correlation between the market’s downward lurch and Karen’s and my return Sunday from the Arctic Circle seems mathematically irrefutable.  Shoulda stayed in Helsinki.

I wouldn’t have minded more time in the far reaches of Sweden and Finland viewing northern lights, sleeping in the Ice Hotel, riding sleds behind dogs, trekking into the mystic like Shackleton and Scott, gearing up for falling temperatures.  We unabashedly endorse Smartwool and Icebreaker base layers (and we used all we had).

Back to the market’s Arctic chill, was it that people woke Monday and said, “Shazam! This Coronavirus thing is bad!”

I’m frankly stupefied by the, shall we say, pandemic ignorance of market structure that pervades reportage.  If you’re headed to the Arctic, you prepare. If you raise reindeer, you’ve got to know what they eat (lichen). And if you’re in the capital markets, you should understand market structure.

There’s been recent talk in the online forum for NIRI, the investor-relations association, about “options surveillance.”   Options 101 is knowing the calendar.

On Aug 24, 2015, after a strong upward move for the US dollar the preceding week, the market imploded. Dow stocks fell a thousand points before ending down 588.

New options traded that day.  Demand vanished because nothing stresses interpretations of future prices – options are a right but not an obligation to buy or sell in the future – like currency volatility.

Step forward.  On Monday Feb 24, 2020, new options were trading.

Nobody showed up, predictively evident in how counterparty trading in support of options declined 5% the preceding week during expirations. Often, the increase or decrease in demand for what we call Risk Management – trades tied to leverage, portfolio insurance, and so on – during expirations is a signal for stocks.

Hundreds of trillions of dollars of swaps link to how interest rates and currency values may change in the future, plus some $10 trillion in equity swaps, and scores of trillions of other kinds of contracts. They recalibrate each month during expirations.

They’re all inextricably linked.  There is only one global reserve currency – money other central banks must own proportionally. The US dollar.

All prices are an interpretation of value defined by money. The dollar is the denominator.  Stock-prices are numerators.  Stronger dollar, smaller prices, and vice versa.

The DXY hit a one-year high last week (great for us buying euros in Finland!).

Let’s get to the nitty gritty.  If you borrow money or stocks, you post collateral.  If you hawk volatility by selling puts or calls, you have to own the stock in case you must cover the obligation.  If you buy volatility, you may be forced to buy or sell the underlying asset, like stocks, to which volatility ties.

Yesterday was Counterparty Tuesday, the day each month following the expiration of one series (Feb 21) and the start of a new one (Feb 24) when books are squared.

There’s a chain reaction. Counterparties knew last week that betting on future stock prices had dropped by roughly $1 trillion of value.  They sold associated stocks, which are for them a liability, not an investment.

Stocks plunged and everyone blamed the Coronavirus.

Now, say I borrowed money to buy derivatives last week when VIX volatility bets reset.  Then my collateral lost 4% of its value Monday. I get a call: Put up more collateral or cover my borrowing.

Will my counterparty take AAPL as collateral in a falling market?  Probably not. So I sell AAPL and pay the loan.  Now, the counterparty hedging my loan shorts stocks because I’ve quit my bet, reducing demand for stocks.

Volatility explodes, and the cost of insurance with derivatives soars.

It may indirectly be true that the cost of insurance in the form of swap contracts pegged to currencies or interest rates has been boosted on Coronavirus uncertainty.

But it’s not at all true that fear bred selling.  About 15% of market cap ties to derivatives.  If the future becomes uncertain, it can be marked to zero.  Probably not entirely – but marked down by half is still an 8% drop for stocks.

This is vital:  The effect manifests around options-expirations. Timing matters. Everybody – investors and public companies – should grasp this basic structural concept.

And it gets worse.  Because so much money in the market today is pegged to benchmarks and eschews tracking errors, a spate of volatility that’s not brought quickly to heel can spread like, well, a virus.

We’ve not seen that risk materialize in a long while because market-makers for Exchange Traded Funds that flip stocks as short-term collateral tend to buy collateral at modest discounts. A 1% decline is a buying opportunity for anyone with a horizon of a day.

Unless.  And here’s our risk: ETF market-makers can substitute cash for stocks. If they borrowed the cash, read the part on collateral again.

I expect ETF market-makers will return soon. Market Structure Sentiment peaked Feb 19, and troughs have been fast and shallow since 2018. But now you understand the risk, its magnitude, and its timing. It’s about collateral.  Not rational thought.