Saturday, May 22, 2010

The Paradox of Market Chaos?

Zachary Goldfarb of the Washington Post reports, SEC launches inquiry into market's 'flash crash':

The Securities and Exchange Commission is looking at whether key financial firms broke securities laws when they stopped buying and selling stocks during the "flash crash" on May 6, helping fuel the historic plunge in prices.

SEC Chairman Mary Schapiro said at a congressional hearing Thursday that these companies, known as market makers, might have violated a legal duty to continue to buy and sell during the rapid decline.

"We don't have evidence yet of market makers who had affirmative obligations from withdrawing from the market," Schapiro told the Senate banking committee. "It is absolutely something that we're looking at and we've incorporated our enforcement division into our ongoing investigation."

Schapiro's comments are the first signal that the regulator might seek to sanction firms if they contributed to the decline of nearly 1,000 points in the Dow Jones Industrial Average. The agency previously had not suggested that wrongdoing could have been behind the market chaos.

At the hearing, the chairman of the Commodity Futures Trading Commission said the regulator would look into reining in some of the high-speed, mathematics-driven trading that aggravated the volatility.

"A lot of the algorithms are very . . . dumb," said CFTC Chairman Gary Gensler. "We can't stop technology, but I think that we have to update our regulations to stay abreast of this."

Regulators suspect that automated trading in a speculative financial instrument linked to the performance of the Standard & Poor's 500 stock index contributed to the market plunge.

But even if trading in that instrument helped fuel the start of the decline May 6, regulators say the failure of market makers to remain active buyers and sellers of shares sent prices down even more.

Many long-time market makers -- often a major bank or brokerage whose role is to facilitate trades by others -- required to remain active in the market even during times of market stress. But many other upstart firms, often using high-speed electronic trading, face no such legal obligation to keep buying and selling shares.

"I do believe one of the things we absolutely have to look at is the fact that many affirmative obligations of market makers have been eliminated by the markets over the years," Schapiro said. "So one of the things we will be looking at very carefully is the creation of affirmative obligations again."

The SEC has discounted the possibility that an error at a financial firm caused the crisis, or that outright criminal behavior such as hacking or terrorist activity was behind the market chaos.

The agency has largely blamed outdated and inconsistent rules governing trading across a wide array of market venues, as well as speculation in electronic futures markets for fueling the plunge.

One thing I try to explain to people is that erratic market moves have much less to do with fundamentals and more to do with banks' prop desks and hedge funds flows. Big banks made a killing in the first quarter of 2010. In fact, the FDIC reported that nationwide, U.S. banks reported an aggregate profit of $18 billion during the first quarter, up considerably from the $5.6 billion profit recorded in the first three months of 2009.

Where are these profits coming from? Certainly not from lending to small & medium sized enterprises. The bulk of the profits at the big banks are coming from trading revenues and most of these are driven by huge algorithmic trading activities performed by an army of PhDs running ultra fast supercomputers, looking for the slightest discrepancy in asset prices.

And what about hedge fund flows? Earlier this week, Boyd Erman of the Globe & Mail reported, Hedge funds rebound, head for $2-trillion in assets:

Hedge funds are hitting some old high-water marks, with assets in North American funds topping the $1-trillion (U.S.) level for the first time since November of 2008, according to tracking firm Eurekahedge.

Globally, hedge fund assets have passed the $1.5-trillion level and are likely to surpass $1.75-trillion by year-end at the current pace.

It's a big turnaround for a group that had some of the biggest winners and losers of the crisis. On the winning side, funds like Paulson & Co. took home huge returns from bets against housing. Losers found themselves long equities or mortgage-backed securities in 2008, then had their pain compounded by margin calls on their leveraged portfolios.

For the moment, some of the hottest returns are at distressed debt funds as default rates have proved nowhere near what was priced in at the nadir of the crisis.

Eurekahedge said distressed debt funds have posted 13 months straight of positive returns, giving them a 50 per cent gain since March of last year.

Two trillion in hedge fund assets may not sound like a lot, but when you add leverage, it's huge. Many of the larger hedge funds also engage in algorithmic trading and OTC derivative trading, adding more volatility in market moves.

I bring this up because it baffles me when "experts" compare today's markets to those of the 1990s, 1980s or 1930s! The structural changes in the markets are huge, bringing more volatility in periods of uncertainty, and less in periods of stability.

And what really concerns me is what effects this will have on defined-benefit plans and individual retirement plans. Moreover, the Prime Minister of Greece, George Papandreou, raised an important point last week in his interview with CNN's Fareed Zakaria. Mr. Papandreou addressed the "paradox" of bailing out banks that turned around and funded hedge funds that speculated on sovereign debt:

MR. F. ZAKARIA: You know, you are in some ways the bellwether for the Western world. You are the first Western country that is going to try in a comprehensive way to pare back some of the excessive guarantees, commitments and expenditures of the welfare state.

Do you think you can do this and survive politically? I know that you made a reference to taking a voyage like Odysseus, and a Greek columnist said yeah, but it took Odysseus ten years. All his comrades died, and he ended up naked and washed ashore in Ithaca. Do you think you’ll have a few more people than Odysseus did, when this journey is over?

MR. G. PAPANDREOU: Well, we know that these journeys are not easy and there are casualties. But we also know we can reach this goal.

What we lived through in the last few months was also somewhat of a paradox, because – and again I am not trying in any way to get away from our responsibilities; we are fully aware of our responsibilities and what we must do – but there are also the financial markets.

In 2008 we had actually the governments coming in to bail out the financial markets and the banks. They had to accrue a huge debt very often, for stimulating the economies, so that we don’t go into not only a recession but a deep depression.

Now you have banks funding hedge funds. They are actually then betting against governments that had actually helped the banks.

So this is a paradox, and I think this is where we need to also regulate markets.

MR. F. ZAKARIA: Do you think that Greece was a victim of the American investment banks?

: We right now have a parliamentary investigation in Greece, which will look into the past and see how things went the wrong direction and what kinds of practices were negative practices. There are similar investigations going on in other countries, and in the United States.

This is why I think yes, the financial sector – I hear the words ‘fraud’ and ‘lack of transparency.’ So yes, there is great responsibility here.

: Could you imagine going after any of these banks legally? Do you see that you have some legal recourse?

: I wouldn’t rule out that this may be a recourse also, to go into this legally. But we need to let the due process proceed, and then make our judgements once we get the results from the investigations.

: And do you think you will make it, like Odysseus, in the end, personally, politically?

: I am doing what is best for my country, and I think that’s the best way to make sure that this country does get to its destination, which is Ithaca.

What happens to me is of less importance, as long as I feel that I am doing what is best for my country and I can sleep well at night, with my conscience clear, that maybe taking very tough decisions and decisions that very often hurt, not only me but also many of the Greek people, but in the end knowing that this is the best.

On Friday, I had lunch with a buddy of mine that came in from Greece. He told me that he was surprised with the speed that Papandreou's government is moving to implement reforms. He also told me that many of these reforms are hurting individuals like his aunt who was a school teacher for many years and is now seeing her pension decline from 1,200 euros a month to 900 euros a month.

As far as speculators are concerned, my friend told me: "I told you a long time ago that major financial regulations are coming". Indeed, politicians are not going to let hedge funds and banks run amok, threatening the integrity of the capital markets and the global economy.

Let me be clear on something: I'm not against hedge funds or banks with huge prop desks. They provide liquidity to markets and hedge funds that deliver true alpha (not levered beta) are worth paying fees for.

But the paradox remains. Banks that got bailed out are funding hedge funds and so are public pension funds looking to increase their leverage to meet their required actuarial rate of return. What worries me is that by doing this, they're increasing systemic risk. Without taking into account their collective actions, they're sowing seeds of more market chaos.

This is something which needs to be addressed on a global level. Individual countries are powerless to deal with these structural changes and their implications for global systemic risk.

Finally, as you listen to Mike Ryan, head of wealth management research for the Americas at UBS Financial Services Inc., talking with Bloomberg's Matt Miller and Carol Massar about the outlook for U.S. equity markets and prospects for a continued U.S. economic recovery, keep in mind the structural changes I discussed above. Nothing shocks me anymore. Erratic moves have become the norm, not the exception.

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