Understanding Market Evolution, Part IV: Examining the Short Term Forces

Understanding Market Evolution, Part IV: Examining the Short Term Forces

By George Bollenbacher, Capital Markets Advisors, LLC

In the last section, I discussed the impact of long-term evolutionary forces on market participants. Now it is time to look at the short term forces at work.

Short Term Forces in General

The first thing we need to know is that short term forces are almost always longer-term forces that build up over time and are triggered by some event. So we need to understand both the force (and its cause), and the trigger (and its cause). One recent example of a short term force is the bursting of the credit bubble, concentrated in the U.S., during 2008 and 2009. That bubble accumulated over at least ten years, until the overhang of unjustified borrowing collapsed the supporting structure, in the same way snow cover builds up on a mountainside until it lets go in an avalanche. At that point, a collection of rapid events overwhelmed the markets until some form of stability was reestablished.

So, in order to make sense of short term forces, both in the recent past, and in the near future, we must first look at the suppressed long-term forces, then at triggers, and finally at the effects of the avalanche. Let’s start with…

The Credit Bubble – All credit bubbles are a result of too much credit chasing too few quality assets. Whatever its cause, once this one got out of hand it’s bursting brought the world’s economies to their knees. With regard to market evolution, it brought into sharp focus the interconnectedness of all the financial markets, not to mention all financial institutions. So one important evolutionary result was an almost maniacal emphasis on risk, both market and counterparty/credit. It also pointed up several potential flaws in the markets, such as the opacity of counterparty relationships or the actual risk exposures of many of the largest participants.

But perhaps the biggest impacts the bubble had on market evolution were the ripple effects of the Lehman bankruptcy and the Reserve Fund’s breaking the buck. In both cases, something happened that the market thought was impossible, and together they brought on the next short term force…

Regulatory Reform – The long-playing soap opera of global market reforms has had many reverberations, such as higher costs for all market participants, conflicts between national regulators, and a boom in the compliance industry. However, its evolutionary implications are only now becoming apparent.

One result of the regional/national patchwork is the global balkanization of the markets themselves. As dealing across boundaries becomes more and more of a regulatory nightmare, more and more participants are deciding to deal only with counterparties in their own jurisdiction. The first market where we are seeing this is derivatives, but, as MiFID II and MAR come on stream we are likely to see it in such mature markets as equities, fixed income and even currencies.

Another result is a heavier reliance on technology for compliance, particularly in the pre-trade arena. Whether it is in business conduct under Dodd-Frank, market abuse under MAR, or the trading obligation/best execution conflict under MiFID, nobody in the market, whether dealer, asset manager, prime broker, or venue, can afford to rely on manual decisionmaking or surveillance. The inevitable, if rare, compliance failure will only be excusable if the market participant was relying on an application that was previously deemed acceptable by the regulators.

Monetary Policy – It can certainly be argued that this force isn’t really short-term, since we have had extraordinarily low interest rates worldwide for almost ten years. However, we can and will argue that it is still a temporary phenomenon. The ways in which current monetary policy affects market evolution are often camouflaged, but they are there nonetheless. One major effect has been the drop in revenue for, and the drop in the number of, FCMs worldwide. This may have exposed a flaw already existing in the business model of the clearing firms, which may simply accelerate the changes already occurring there, but the changes are happening quickly.

Another monetary policy effect is what will happen when rates start to go back to what everyone thinks of as normal levels. Here the impact is based on what short term investors have been doing to enhance their yield under the current conditions. If bank portfolios, money market funds, pension funds, and corporations have been reaching out on the maturity curve and down the quality spectrum for yield, will there be a mass exodus from those market segments when it looks like more attractive yields are on the way?

That question highlights the third effect of current monetary policy, the reduced volatility of most markets. Reduced volatility leads to reduced spreads, which leads to reduced liquidity as market-makers decide there isn’t enough trading volume or profit to stay the course. Whether it is evidenced in the historically low number of primary dealers in the U.S. government bond market, or the withdrawal of several of the big banks from market-making in many of the lesser markets, we are seeing the markets adapt to these evolutionary forces, which may suddenly change back.

Short Term Effects

So do these short term effects accelerate the long term ones, inhibit them, or operate in completely different spheres? Let’s look at them in relation to the long term forces we discussed earlier.

The March of Technology – Here the short term effect is clearly to accelerate the change. Whether we are looking at the increased regulatory burden or the greatly reduced market spreads, the immediate answer to most of the short term forces, as well as many of the long-term ones, appears to be implementing more advanced technology across a wider range of functions. Some of these functions are repetitive and relatively simple, like cross-margining, while others are nuanced and challenging, like investment decision making, but we can expect many of them to be done by algorithms in the future.

For some people, this raises the specter of a Matrix world, where people are walking around unaware that everything they do is dictated behind the scenes by a computer. For others, the risks to the markets are paramount, and for them the recent spate of flash market events are warnings that algorithms don’t have the judgment that human traders do, and we turn our trading books over to them at our peril. And the regulators are walking the tightrope in the middle. But none of that will change the direction of the evolution.

The Changing Vendor/Client Relationships – In this area the short term forces are also accentuating the long-term ones, although this process is much more disparate. In some cases, such as derivatives clearing and market-making, both the long-term and short term economics are clear, and the markets are adjusting accordingly. In others, such as specialized asset management or trade settlement, the process is more protracted, and sometimes appears not to be happening at all.

But whether current vendors are abandoning the market in droves or fighting to maintain their positions, change is in the air across the board. And it is important to note that this kind of change usually isn’t initiated by the clients, but by the vendors. The most contentious kind of relationship change is when vendors begin to bypass their clients, in order to access their clients’ clients. This is always a high-risk strategy, of course, but the alternative may be to hang on to a degrading relationship while a competitor swoops in and makes you yourself obsolete. Once again, doing nothing in the face of change buys you a place at the fossil display.

The “Catch-Up” Nature of Regulation – This regulatory problem becomes most apparent when we look at it in relation to the long-term forces. In particular, we need to look at the effects, both intended and unintended, of regulatory changes, and how they interact with the long-term trends. The most obvious dichotomy is the problem of regional regulation in global markets. This is a prime example of short-term events in direct opposition to long-term trends. As market participants weigh the decision to compartmentalize their business along regulatory boundaries, they have to give consideration to the longstanding migration toward “boundaryless” transactions.

Since regulation is itself a moving target, everyone is balancing the effort of complying with the latest emanations from ESMA, or the SEC, or the Japanese FSA, or the Canadian CSA, against the ceaseless drive toward global market efficiency. The hidden risk is that one relies too completely on the regulatory hodge-podge, only to be caught flat-footed if and when the regulators get their respective acts together. One solution not yet fully explored is that market participants attempt to operate in a “stateless” form, on the assumption that such an approach obviates much of the regulatory jungle. For many, this is the Gordian knot of modern markets. Now where did I put my sword?

In the next section, I will look at several principles for dealing with market evolution.