November 13, 2013

Wag the Dog

Today a new era begins.

One day in May 1792, 24 brokers gathered beneath a buttonwood tree in lower New York City and agreed to confederate in conducting their stock-in-trade. Thus began the New York Stock Exchange.

Today, the NYSE is slated to cease trading publicly. The InterContinental Exchange – The ICE – cleared final regulatory hurdles and closed the transaction.

It’s a study, an archetype, of the monumental change these last 15 upending years in equities, that The ICE is a derivatives market that didn’t exist when the Order Handling Rules in 1997 fundamentally shifted market orientation from investing to intermediation.

You’ve heard the cliché about the tail wagging the dog? Derivatives depend for existence on some underlying thing, an asset. Where derivatives have exploded in securities markets everywhere, equity assets have shrunk, not in value but in number. Keep this thought in mind. We’ll come to its significance.

According to SIFMA, the trade association for US capital markets, interest-rate derivatives alone reflect about $600 trillion of notional value. Compare to assets from US investment companies directed at US equities, according to consultancy Towers Watson and the Investment Company Institute: Roughly $11.4 trillion from a total $34.2 trillion under management. Dwarfed.

Sure, other assets in US equities originate internationally. But there’s been a colossal shift since 1972 (an ironic numerical anagram), when derivatives began to percolate globally as first the dollar and then the raft of global currencies departed from mooring gold, creating value uncertainty that had to be hedged in securities markets.

The pace gained steam in the 1990s and in equities it coincided with a reversal in the number of public companies in the National Market System. That figure peaked near 8,000 in 1998, data from Wilshire Associates shows.

Today, the Wilshire 5000, the broadest national-market measure, counts about 3,600 components. Strip out ETFs and other exchange-traded products. Closed-end funds, investment companies, multiple stock classes. Nitty-gritty individual companies aren’t half what they were 15 years ago.

Yet derivatives boomed. There are two million global indexes, summing those from FTSE, S&P Dow Jones, MSCI, Russell Co., NASDAQ OMX and other smatterings. Just some thousands of these are tied directly to US equities, true, but it’s many more than all underpinning companies – upon which these derivatives depend.

What does it mean when derivatives outstrip the assets from which they’re derived? It’s a form of credit. A reflection of uncertain values. When purchasing power fades, paper expands to fill the gap.

Thus everything now is intertwined. The Aug 22 technology glitch that halted NASDAQ trading for three hours traced to repeated failure in the connection between that that exchange and NYSE Arca, a big derivatives market (that’s what Tape B securities are). A day earlier, Goldman Sachs’s automated options-trading algorithms –options are derivatives – erred and had to be terminated, costing that firm $100 million. Derivatives got the blame for the original technology glitch, the May 2010 Flash Crash.

Statistically, the price in your shares is more likely to be set by derivatives than by the asset – your fundamentals. The tail is wagging the dog. The derivatives exchange has swallowed the asset market.

We’re not negative on this deal. To the contrary, we’re excited to see what comes. But what’s derived from your shares –indexes, swaps, options, futures, contracts for differences, ETFs and so on – in some sense carries the greater weight.

Seen another way, credit is more vital than net worth. That’s a big deal.

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