May 15, 2013

Swapping the Future

Whole swaths of stocks moved 3% yesterday. You might thank Dodd-Frank for it, even if David Tepper gets credit (if you heard the Appaloosa Management founder’s interview you know what I mean).

To understand how, ever heard of a Rube Goldberg Machine? It’s an unnecessarily complex device for doing something simple. Cartoonist Reuben “Rube” Goldberg turned his own name into a rubric for obtuse machination with humorous creations like the self-operating napkin.

So your stock rose sharply for no apparent reason. Some will say it’s because David Tepper, who made $2 billion last year on a belief in strong equities, said on CNBC that “shorts should get out the shovels because they’ll be buried.”

But the answer to why your stock and maybe your sector yesterday moved, and how Dodd-Frank is a factor may be more like a Rube Goldberg Machine. MSCI global indexes rebalance today, and ahead of that we’ve seen surging high-frequency trading, telling us money is benchmarking ahead to equity indexes at newly higher rates. Options expire tomorrow and Friday, with VIX volatility instruments lapsing May 22, giving arbitragers better opportunity to pairs-trade.

And Dodd-Frank’s deadlines on swap-clearing rules take effect in June, so this is the last pre-central-swap-clearing options-expirations period, which set dates for swaps too.

Ever heard of single-stock futures? It’s a way to go long or short shares without buying or borrowing. There’s even an exchange called OneChicago owned by the Chicago Board Options Exchange, CME Group, and Interactive Brokers, for electronically trading these contracts where two parties agree to exchange a set number of shares of a given stock in the future at a price determined today. Also popular are Narrow-Based Indexes – futures contracts on a small set of securities, say, from an industry or subsector.

Any of these instruments used as hedges could be subject to Dodd-Frank provisions requiring “securities-based swaps” to be centrally cleared. Those rules are now final and take effect June 10, 2013. Before Dodd-Frank, conventional wisdom said you could never centrally clear total-return-style swaps in which parties are trading risks and returns. They were too complicated, folks said.

In fact, many prime-brokerage accounts are like total-return swaps, where the broker owns the shares and the client puts up margin and trades them under an agreement. That’s another reason shares can gyrate at options-expirations. A client cashes out and stops trading, and the broker-dealer dumps the inventory and down go your shares, and you wonder who’s selling? Just a dealer with inventory.

Also, leveraged ETFs are in many instances nothing more than total-return swaps resetting every day. They don’t actually own shares.

So here we come to the final expirations period before many of these instruments must be centrally cleared. Anonymity could be compromised. Returns for users go down because there are new fees to pay, more compliance costs.

Enterprising hedge funds, perhaps even ones like David Tepper’s, might have gone around right after options expirations Apr 17-19 and bought up contracts, knowing that marching deadlines might make holders take a little something over a lot of nothing. Then right before May expirations, hedgies aggressively trade up equities and exercise those contracts. Stocks in disparate formation move 3% as counterparties or holders are forced to make delivery. Possible?

The bigger question is what happens to trading after June 10. Is the forced clearing of agreements long thought too unique for centralization going to alter market behavior? Maybe Rube Goldberg could give us the answer.

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