April 16, 2014

Fires, Crashes and Kill Switches

Suppose the engine of your vehicle was on fire.

The logical response would be to shut it off. But what if you were traveling at highway speed and killing the fuel supply meant you had no power breaks or steering? What if your vehicle was a jet fighter?

There are ramifications.

Last Thursday and Friday stocks plunged. Monday and Tuesday this week, shares soared. I doubt most of us think that people were selling in a stampede last week and then woke up Monday and went, “Shazzam! What have we done? We should be buying!”

Context matters.

This week offers an event in similar rarified air as blood moons in the northern hemisphere. Good Friday closes markets to end the week. Between are the usual three sets of expirations: volatility derivatives, index futures, and the remaining host of options and futures set for monthly expiry (with earnings now too – another reminder for you learned IROs to avoid that mash-up if at all possible).

There are but two days for all three. Some wild concoction will brew up in the market blender. If you were a volatility trader, last week’s sharp declines presented a compelling chance to trade equities up into today’s VIX expirations. Mission accomplished.

But how does that affect risk managers calibrating hedges in markets overhung by a Putin pall and a sudden scurrying of high-speed cockroaches in the blinding Michael Lewis glare (no offense, HFTs)? Good question. Internally, we never like to see stocks jumping before expirations, as it often means investors are monetizing insurance policies and leaving equities until the cost of protection falls back to earth.

It’s no absolute. The 10-point ModernIR Behavioral Index, bouncing like a contestant on reality TV’s Wipeout, sits April 14 near 4, just shy of a market-bottom signal. When the behavioral measures seem schizophrenic, it’s not the measures but the money.

Which brings us back to the proverbial engine fire and kill-switch. Columbia University’s economics Nobel-prizing-winning professor Joseph Stiglitz (who uttered one of my top-ten favorite quotes: “dollars are depreciating assets”) yesterday said we should tax high-speed trading to stop front-running. That’s like telling everybody to stand up and fining anyone not sitting down. HFT is a product of rules. It’s hitting the kill-switch before realizing you’re flying a jet fighter (parachutes, anyone?).

The taxonomy, pun intended, of market structure today coalesces around the fighter jet of high-speed trading. Rather than killing the engine, we should contemplate first landing the aircraft. Otherwise, we don’t know where it’ll crash and who’ll be hurt.

This is not reason to ignore the problem, but a prompt for a plan of action. Were it up to me, I would propose three steps (Lynyrd Skynyrd playing in background): First, improve trading data for everybody. FINRA could provide complete broker volumes with long-short activity on a one-day delay. Brokers are the conduits, so investors, get over it.

Second, drag issuer-ownership data into the 21st century. If money managers provide clients with monthly statements, public companies should know monthly who owns shares. It’s not directly related to market structure but the bright light of day for all is a first principle.

Finally, how about permitting a couple exchanges to voluntarily disconnect from the national market system and run standalone? Let the market figure out what works. Millions of sentient beings motivated by self-interest are inherently better insurance against risk than the opinions of five regulators in a Washington DC room.

The engine may well be on fire. But we don’t want a fiery crash.

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