Thursday, December 08, 2016

Deregulating algorithmic trading in derivatives in commodities could be fatal to the economy

It has been well known for some time now that a faction of derivatives traders (specifically the High Frequency Trading (HFT) Algorithm types) are opposed to any form of government intervention in their business sphere.

The ill-effects of the HFT approach to the market are well known. Briefly - given that these machines trade on timescales too fast for human intervention, they often introduce volatility shifts in the market. The derivatives market is particularly susceptible to such shifts as volatility is one of the main considerations in determining the price of a derivative.

Trade in derivatives by various groups of investors has become very popular. As these derivatives are relatively lower cost than the underlying asset, people from all over the world are putting their earnings into the derivatives market. Some people are buying these derivatives in the belief that it is an "insurance policy" of some kind - while others are seeing these instruments as a way to make a quick buck on a market trend. The entire process is rife with speculation as it is impossible to efficiently compute the true rate of change of an asset price.

Given how few people understand the real risks associated with owning these derivatives, we are seeing conditions similar to 1929. In 1929 the communication technology was slow and most investors that lived far away did not have time to respond to the market shifts and correct their positions in real time. The people closer to the exchange - were able to offload their assets as they heard the news first (kind of like an HFT algorithm today). This is the classic "short selling" maneuver.

Unfortunately the investors close by did not appreciate the effect of the communication system on the entire market. As investors far from NY heard about the initial downturn a day after it took place, they sold their securities and these trades hit the market much later in the week. The investors who were closer to the market found their short selling maneuver failing as the prices continued to plunge. So they doubled down on their shorting strategy and sold off more stock causing the prices to drop further.

The news of the new drop in prices caused took a while to reach the far-away investors and their response took another day to impact the market. In this fashion the crash progressed - what might only have been a small time-scale fluctuation coupled to a longer timescale information transport process and the panic set in.

The HFT algorithms operate in a similar space and that generates similar risks. Major institutional lenders are directly or indirectly exposed to these risks and many commodity based funds are also exposed. I would even say that nothing is practically safe from exposure right now.

Everyone knows that commodity trades are the foundation of the market, but very few people realize that all the commodity segments - soft, hard and energy are inter-linked. If the price of oil goes up, the price of corn will do the same. If corn rises, so will beef and pork. If beef and pork rises - so will poultry and dairy. It is very dangerous to encourage volatility in any part of the commodity markets. Given how badly stretched the productivity of these sectors is - an increase in volatility could cause supply side fluctuations. Once supply side fluctuations set in the soft commodities - you are staring at a Bengal 1943 scenario.

The Dodd-Frank Act of 2010 seeks to limit the speculative impulse in the markets and directs the Commodities Futures Trade Commission (CFTC) to come up with highly specific proposals to curtail speculation via HFT in derivatives. This has already been identified as a key target for market regulators.  Currently one of the CFTC commissioners Christopher Giancarlo has been pushing back against  specific implementations of  the Dodd-Frank Act.

Christopher Giancarlo is rumored to be very close to President Elect Donald Trump. It is also well known that the Mercer family which owns one of the biggest players in the HFT business supported the Donald Trump Campaign. Robert Mercer is one of the CEOs of the highly successful Renaissance Technologies, which is in the business of using HFT algorithms for all manner of things.  And while it is hard for me personally to speak ill of an organization that uses so many Physics, Math and Computer Science PhDs - I feel we may have a problem here.

Designing a boutique model that fits a given data set and then designing an algorithm that exploits knowledge of the model predictions is one thing, but no model is perfect. In a natural system, prediction always falls short of reality. One has to recognize what the cost of such a failure is. If you work at Renaissance Technologies, you should review the existing literature on the Manhattan Project and the views of the key scientists there. Every action has unanticipated consequences - the Manhattan Project people found that out the hard way.

As things stand the CFTC Chairman Massad has indicated that they will not be implementing new specific measures to discourage speculative trading the energy and hard commodities sub-segments.  As Christopher Giancarlo is tipped to the be the next Chairman of CFTC, people seem to think that clashes with the spirit of the Dodd-Frank Act will not be a real problem going forward.

I feel we should all remember the big picture:

Commodities trades are the root of the economic order. All commodity trades are coupled in complex ways. Introducing volatility into this space creates a likelihood for supply side fluctuations. Once those supply side problems set in - it is highly unlikely that the US Government or the Federal Reserve will be able to do anything to stop the economic crash that follows. Given the precarious situation with government debt, if the market crashes like that then it is likely that major economies like the US, Japan, UK will end up in defaulting on their bonds or gilts. The global economy will take several decades to recover from that kind of massive economic collapse. 

Deregulating HFT of commodity derivatives seems to be a very short path to this hell. It is best to stick to the requirements of the Dodd-Frank Act. 

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