August 2, 2011

Market Mayhem and Large Traders

Why are markets dropping like the thermometer at 8pm on Pike’s Peak?

Debt chaos, sour economic data, sure. We’re not market prognosticators, we track behavioral data. Under the skin of the news at market level, institutions shifted to managing portfolio risk about July 21. These events were observable. Algorithmic execution changed, and we saw what started it and what followed.

Large diversified asset managers swapped out of equities. That means they assigned the risk in portfolios to others through agreements that traded risk for safety at a cost. Why not just say “investors sold to manage risk”? It’s not accurate and it won’t be reflected in settlement data.

Of course, hedging produces a range of consequences too. Those underwriting hedges themselves hedge the risk they assume. That prompts speculating in whatever instruments are being used to hedge the hedges. The idea is to offset every point of exposure – like double-entry accounting, a credit for every debit.

Consider the Treasurys market – the one in peril till today. Primary dealers ranging from Banc of America to Goldman Sachs make markets in Treasurys. Average daily trading volume in Treasurys is more than $500 billion. Bond trading in total in the US averages more than $950 billion daily and nearly 80% is government securities.

There is searing growth in Treasury futures and options trading, which increased by 48% in the March quarter at the Chicago Mercantile Exchange. The daily currency trading market averages nearly $4 trillion in notional value. The same firms that dominate equity program trading and the Treasury market – the biggest bulge-bracket firms – are kingpins in currency trading.

GETCO, which stands for Global Electronic Trading CO., says it focuses on “helping investors efficiently transfer risk.” GETCO is both a designated market maker on the NYSE floor and a global proprietary trader in multiple asset classes. GETCO is an example of the role intermediaries play now, whether liquidity providers or market makers. They move money fluidly from place to place so debits and credits offset in large institutional accounts, and risk diminishes.

This is what institutions were doing starting July 21. The effects of hedges to manage risk, and hedges to manage hedges, and speculation between, is now afflicting US equities. Daily dollar volume in US equities is about $100 billion, a fraction of some other asset classes. Reweighting portfolios to reduce risk by moving from assets to derivatives has a big effect on market value.

Which brings us to large traders like GETCO. The SEC issued Rule 13-h1 requiring large traders – those trading more than $20 million daily or $200 million monthly in NMS equities – to register. There is a fear that these large traders are culpable for market risk.

Yet large traders exist principally because SEC rules fragmented markets and turned them into automated, high-speed risk-transfer devices rather than places where capital is formed. The construct hinges on liquidity from large traders. And the SEC is now penalizing those participants, whose presence they encouraged.

And what about trading in currencies? Bonds? Treasurys? How about grey-market securities where NMS rules don’t apply? Imposing restrictions in one class without doing so in another will produce migration and regulatory arbitrage. And what’s to stop large traders from fragmenting operations into units that trade less than $19 million daily?

The rule is 179 pages long. There are exemptions. The SEC admits it lacks jurisdiction over certain foreign large traders whose countries’ laws prohibit disclosures the SEC seeks. They can apply for an exemption. In effect, the SEC will demand more disclosure from traders in the land of the free where privacy is sacrosanct than what many foreign jurisdictions allow. Take Brazil’s Latour – now #6 among program traders.

While not the intent, the effect may be that US firms are disadvantaged in their own markets by rules that don’t apply to international traders. What’s more, only firms that exercise discretion over funds can qualify as large traders. Large traders might contract with agency brokers and lease their algorithms to skirt the rule.

Rule of thumb: If your rule does not apply to everyone, scrap the rule.

And we will have accomplished exactly jack-zero in preventing nefarious behavior. We’ll have driven more competition from markets, created greater cross-asset-class risk, and stultified and constipated markets where rules are supposed to avoid impeding free function. And worst, we will have exacerbated the confusion, complexity and inconsistency crippling our capital markets.

We don’t embrace high-frequency trading. But another 179-page rule is no solution, and no help to public companies. The path to freedom and health is simple: junk the rule-structure that favors high-speed arbitrage. Reg NMS. We don’t need a national market system. Money could not arbitrage prices in multiple markets if the SEC didn’t demand that all the markets display their prices. I’ll be blunt: it’s crazy.

Imagine how markets would thrive if we blitzed this convoluted mess and started over with basic rules that everybody regardless of size or speed could follow.

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