May 25, 2010

Guitar Hero of Trading Markets

Does it feel like the beatings will continue until morale improves?

What’s happened today is straightforward: Investors and counterparties – think of it like vacationers and providers of trip insurance – sorted out imbalances. The debits and credits were entered on ledgers last week with monthly options expirations. Yesterday, true-ups hit Asian and European markets. Today they rippled through ours.

We’ve got more to say about it, but let’s get there by way of DRW Trading Group and the Eurodollar. DRW is a finite example of prevailing trading realities. On May 21, DRW suddenly appeared in many equity trades. DRW trades in various asset classes around the globe at high speeds. Ever played Guitar Hero? Imagine following the blinking lights, putting your fingers in different spots and removing them. Your speed and accuracy in placing and removing your fingers determines your success at the game.

Same principle applies. DRW’s founder Don Wilson earned his stripes long ago trading Eurodollar futures. Eurodollars are dollars — not Euros at all — on deposit in European banks, and futures contracts on them have to do with interest rates and currency values at future points.

If your eyes are glazing over, stay with me here! This cuts to the IR quick. How do shares of biotech stocks in US markets relate to Eurodollar futures traded by high-frequency quantitative proprietary firms like DRW? It’s an example and we’re both simplifying and postulating to explain what occurs.

But it’s like this: the supply of currency in central banks in one part of the world acts directly on the price of things in another part. If you can trade instruments denominated in those currencies fast while betting on where the supply will land and how it will affect interest rates three months from now, you have an interesting trading scheme that drives some poor IRO at a Nasdaq-traded biotech company over the edge because the trading makes no sense.

Yet in complex algorithms, the math fits, well, like fingers on a fret board. These global inequities are normal and huge in trading activity now. And they’re brought to you by your friendly neighborhood sovereign central bank.

Which brings us back to trading today. It’s a rule of thumb in trading markets that what happens tomorrow reflects what occurred yesterday. This is also true with weather, human relationships, your cholesterol count, and sovereign balance sheets. Remember back in April when we said there were serious risk-management issues for equities? By April 27 they were a big deal, and on May 3 they bumped up to dire. Risk managers and their counterparties were sorting out discrepancies.

Thus, on May 6 we all saw the divide between actual values and the synthetic coating on the markets. The real value of the markets was a thousand points – at least – below where markets stood on May 6. Regulators responded with beatings in the hopes that morale would improve.

So today, we’re about where we were midday May 6. It happened this way. Options expired May 19-21. We saw hedge resets hitting some equities May 18. By May 21, market structure looked very similar to what we saw on May 3. Now two trading days later, the shoe drops in the markets as true-ups occur.

There’s good news: Hedge resets stabilize markets. Data suggest that despite governments shifting massive monies by swaps to and from central banks, which serves up a slow pitch for global arbitragers, market forces faced the hurricane winds and winnowed risks. For now. While it’s impossible to know what synthetic thread will come undone tomorrow, taken at face value, resets mean we can expect better performance in markets for a brief spell.

And further good news: These problems can be solved with the diametric opposite of what we’re doing. We’re at logical loggerheads. Regulators want to achieve stasis. All physics reflect constant change. The more things are subjected to controls, the less things function naturally and the more markets become defined by arbitrage. Solving a price-discovery problem will not happen through controls (Germans, are you listening?). 

What to do meantime, IR professionals? Adapt to conditions. Don’t expend effort on value investors when markets are teeming with arbitragers. They’ll find no liquidity.  You’ve got to factor market structure into your thinking, or you’ll spin your wheels.

Be nimble, be quick! When the wind stops, get on that bike and start couriering some good news to value buyers. Life in the IR chair for now must be speedier than before.

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