Robots have hijacked the market
It has been comical to watch the parade of guests on the business news channels this week try to explain to viewers, and to one another, why our hyper-efficient financial markets — the ones that are supposed to be so brilliant at pricing the value of everything — have been bouncing around like a squash ball on an overheated court.
Pay no attention to the volatility, these financial wizards assure us. It’s just a little technical correction. The fundamentals of our otherwise sound economy will soon reassert themselves.
The truth is that the market is as irrational and divorced from fundamentals on the way up as it is on the way down. It is in the nature of markets more so today than ever, as a result of the computerized highfrequency trading strategies of the Wall Street wise guys. What we’ve watched this week is herd behavior on steroids.
It’s important to remember that a fraction of the trades these days — maybe 10 percent — are made by real-life humans. An additional 40 percent or so reflect decisions to invest in the entire stock market, or an entire industry, or an entire class of companies — index funds, exchange-traded funds (ETFS) or other kinds of passive investments.
That leaves half the trading that is done automatically by computers, according to complex algorithms that focus on changes in market prices or indexes caused by the trading done by other computers. In this kind of robots vs. robots trading with its
circular logic, fundamentals are irrelevant, the volumes are enormous and the holding periods are often a matter of minutes, even seconds. More often than not, a “trade” is likely to be a combination of trades. And almost all of it is done with borrowed money.
One theory about Monday’s 1,000-point plunge in the Dow Jones industrial average had something to do with a trade that shorted an ETF tied to a volatility index, which forced the sponsor of the fund, Credit Suisse, to buy some huge number of futures contracts to balance out its exposure.
The instrument goes by the name of Velocity Shares Daily Inverse VIX Short-term Exchangetraded Note, or XIV for short. It apparently created a vicious cycle in which selling begat more selling and wound up wiping out nearly $3 billion in valuation for investors. Credit Suisse has now announced it would soon stop trading in the instrument.
Aside from the gambling aspect, the rationale put forward for these ridiculously complex instruments and trading strategies is that they reduce price volatility and increase market liquidity, which is true except when it is not, which is precisely at those moments of market panic. Instead of hedging risk, they wind up increasing risks for those who own them and the market in general.
This is particularly true in a market such as this one, where the amount of trading done with borrowed money is higher than it has ever been, as a result of the low interestrate policies of the major central banks that allow hedge funds to borrow $4 or $5 for every one of their own they put at risk. When prices start to fall rapidly, the funds are forced to sell their positions to pay back the banks and brokerage houses, driving down the price even further. Selling begets yet more selling. Investors rushing to cover short positions, or to sell underwater options before they expire, run into a similar dynamic.
What happens with one asset class can affect what happens in all the others. A bubble in Bitcoins can stir what John Maynard Keynes called the market’s “animal spirits,” encouraging investors to take risks and bid up the price of stocks or real estate or fine art. And it works in reverse when fear replaces greed. There’s no rational reason the collapse in bitcoin prices, from $19,500 to $7,500, has any rational connection to stock prices, but as Keynes understood, investors and markets are not rational.
There is no reason a financial system has to be this complex. There is no reason it has to divert so much of the country’s talent and capital, and to siphon off so much for traders and bankers and hedge fund managers. With a bit of intelligent regulation, we could have a financial system that is simpler, less risky, cheaper and less susceptible to manipulation.
There is a cost to the kind of financial “innovation” that produces instruments such as the Velocity Shares Daily Inverse VIX Short-term Exchangetraded Note. My guess is that those costs now greatly exceed the benefits.