Best of the Week
Most Popular
1. Stock Markets and the History Chart of the End of the World (With Presidential Cycles) - 28th Aug 20
2.Google, Apple, Amazon, Facebook... AI Tech Stocks Buying Levels and Valuations Q3 2020 - 31st Aug 20
3.The Inflation Mega-trend is Going Hyper! - 11th Sep 20
4.Is this the End of Capitalism? - 13th Sep 20
5.What's Driving Gold, Silver and What's Next? - 3rd Sep 20
6.QE4EVER! - 9th Sep 20
7.Gold Price Trend Forecast Analysis - Part1 - 7th Sep 20
8.The Fed May “Cause” The Next Stock Market Crash - 3rd Sep 20
9.Bitcoin Price Crash - You Will be Suprised What Happens Next - 7th Sep 20
10.NVIDIA Stock Price Soars on RTX 3000 Cornering the GPU Market for next 2 years! - 3rd Sep 20
Last 7 days
Gold Price Drops Amid Stimulus and Poor Data - 21st Jan 21
Protecting the Vulnerable 2021 - 21st Jan 21
How To Play The Next Stage Of The Marijuana Boom - 21st Jan 21
UK Schools Lockdown 2021 Covid Education Crisis - Home Learning Routine - 21st Jan 21
General Artificial Intelligence Was BORN in 2020! GPT-3, Deep Mind - 20th Jan 21
Bitcoin Price Crash: FCA Warning Was a Slap in the Face. But Not the Cause - 20th Jan 21
US Coronavirus Pandemic 2021 - We’re Going to Need More Than a Vaccine - 20th Jan 21
The Biggest Biotech Story Of 2021? - 20th Jan 21
Biden Bailout, Democrat Takeover to Drive Americans into Gold - 20th Jan 21
Pandemic 2020 Is Gone! Will 2021 Be Better for Gold? - 20th Jan 21
Trump and Coronavirus Pandemic Final US Catastrophe 2021 - 19th Jan 21
How To Find Market Momentum Trades for Explosive Gains - 19th Jan 21
Cryptos: 5 Simple Strategies to Catch the Next Opportunity - 19th Jan 21
Who Will NEXT Be Removed from the Internet? - 19th Jan 21
This Small Company Could Revolutionize The Trillion-Dollar Drug Sector - 19th Jan 21
Gold/SPX Ratio and the Gold Stock Case - 18th Jan 21
More Stock Market Speculative Signs, Energy Rebound, Commodities Breakout - 18th Jan 21
Higher Yields Hit Gold Price, But for How Long? - 18th Jan 21
Some Basic Facts About Forex Trading - 18th Jan 21
Custom Build PC 2021 - Ryzen 5950x, RTX 3080, 64gb DDR4 Specs - Scan Computers 3SX Order Day 11 - 17th Jan 21
UK Car MOT Covid-19 Lockdown Extension 2021 - 17th Jan 21
Why Nvidia Is My “Slam Dunk” Stock Investment for the Decade - 16th Jan 21
Three Financial Markets Price Drivers in a Globalized World - 16th Jan 21
Sheffield Turns Coronavirus Tide, Covid-19 Infections Half Rest of England, implies Fast Pandemic Recovery - 16th Jan 21
Covid and Democrat Blue Wave Beats Gold - 15th Jan 21
On Regime Change, Reputations, the Markets, and Gold and Silver - 15th Jan 21
US Coronavirus Pandemic Final Catastrophe 2021 - 15th Jan 21
The World’s Next Great Onshore Oil Discovery Could Be Here - 15th Jan 21
UK Coronavirus Final Pandemic Catastrophe 2021 - 14th Jan 21
Here's Why Blind Contrarianism Investing Failed in 2020 - 14th Jan 21
US Yield Curve Relentlessly Steepens, Whilst Gold Price Builds a Handle - 14th Jan 21
NEW UK MOT Extensions or has my Car Plate Been Cloned? - 14th Jan 21
How to Save Money While Decorating Your First House - 14th Jan 21
Car Number Plate Cloned Detective Work - PY16 JXV - 14th Jan 21
Big Oil Missed This, Now It Could Be Worth Billions - 14th Jan 21
Are you a Forex trader who needs a bank account? We have the solution! - 14th Jan 21
Finetero Review – Accurate and Efficient Stock Trading Services? - 14th Jan 21
Gold Price Big Picture Trend Forecast 2021 - 13th Jan 21
Are Covid Lockdowns Bullish or Bearish for Stocks? FTSE 100 in Focus - 13th Jan 21
CONgress "Insurrection" Is Just the Latest False Flag Event from the Globalists - 13th Jan 21
Reflation Trade Heating Up - 13th Jan 21
The Most Important Oil Find Of The Next Decade Could Be Here - 13th Jan 21

Market Oracle FREE Newsletter

FIRST ACCESS to Nadeem Walayat’s Analysis and Trend Forecasts

Markets Floor Monkeys and Decentralization of Risk

Stock-Markets / Financial Markets 2015 Aug 01, 2015 - 08:46 AM GMT

By: John_Mauldin

Stock-Markets

As most of you know, I used to be a clerk on the floor of the old P. Coast options exchange in San Francisco. What a place. I could tell stories about that floor for weeks. The craziest things you ever heard.

But let’s keep it professional. The funny thing about a trading floor like the PCX (or the NYMEX, or the CME) is that you have winners and losers. You have big winners and big losers. You have people who blow themselves up. You have people who blow themselves up so spectacularly, they take a chunk out of their clearing firm.


In very rare cases a clearing firm has gone down. But never, ever has a public exchange, a clearinghouse, blown up. Never happened. Probably never will happen. I feel pretty comfortable making that prediction.

It was intended that way. Let’s say you have a crowd of 100 locals in a pit, and some hedge fund calls his broker with such a toxic trade that it blows up a few guys. But the risk is very decentralized. One trader isn’t going to take out the exchange. Even a handful of traders aren’t going to take out the exchange.

The cool thing about public exchanges and open-outcry pits is that they take big risk and turn it into small risk. Which is pretty much the opposite of how we do things today—where we take small risk and turn it into big risk.

Liquidity Providers

The whole business of providing liquidity (which is what floor locals used to do) has changed a lot in the last 20 years.

That is the understatement of the century.

It’s what’s turned the NYSE from a bustling marketplace into a glorified TV studio. It’s what turned the AMEX, the old curb exchange, into… nothing. Not much left at the CME, except for some options pits in the grains and meats.

Naturally, things have become more electronic. Not everyone is happy about that development. I am.

I’ll dive a little bit into the high-frequency trading controversy. It was in 2003 that the NYSE had a massive front-running scandal that nearly resulted in criminal convictions of a few specialists. The futures pits at the various exchanges were known to have shady stuff going on all the time.

The reality is that when you have someone in a privileged position where they can see order flow and position themselves accordingly, they will surely take advantage of it—human or computer. For a number of reasons, I’d rather have the computers.

Except for this: the problem with the current system where a few large firms, electronic trading firms, act as liquidity providers is that they actually centralize, rather than decentralize, risk.

They take small risk (a bunch of little orders) and turn it into big, concentrated risk. Now, electronic trading firms are not in the business of taking big risk—they are in and out of it very quickly, so it’s unlikely that they’d willingly strap on a big position. But a few years back, Knight Capital had a catastrophic trading error that resulted in them having to be bailed out by a group of independent investors.

What if that happens again—even bigger?

These scenarios are very unlikely, but it doesn’t change the fact that we are centralizing risk, rather than decentralizing it. Not good.

Anti-Federalism

It’s actually a general principle that things work better when you break them down as small as possible. This is the principle the United States is founded on—that states and municipalities retain political control.

Problem is, we’ve been concentrating risk everywhere since the financial crisis. I don’t care who you think was responsible for the crisis, the net result of our interventions is that the banks that were too big to fail in the first place are now even bigger. I don’t think that’s progress. I don’t think it’s progress that if anything goes wrong, we put it on the government’s balance sheet.

If I were in a position of authority in the government, I’d spend my time looking for ways to break down risk to the smallest unit possible.

But that’s not what we’re doing. We’re going around looking at things like mutual-fund companies and calling them SIFIs (Systemically Important Financial Institutions) and then regulating them, which will only make them more systemically important. Dumb, right?

What are the chances that we are going to have another big crisis as a result of this? 100%.

I’m not trying to say something splashy. It’s just true.

The target du jour is the corporate bond ETFs, like the iShares iBoxx $ High Yield Corporate Bond ETF (HYG). A liquid claim on an illiquid asset. But having traded ETFs for a number of years, the problem isn’t with the ETF. It’s with the stupid regulations that constrain bond dealers from doing their job. Icahn is wrong.

LTCM

Remember the Long-Term Capital Management crisis in 1998? Pretty good example of risk getting centralized.

But here’s the scary thing. That whole crisis was over seven billion dollars. Seven billion lousy dollars. Amaranth lost almost that much and didn’t even flinch. For Bridgewater, that’s a bad day. Today, the world is a lot bigger and a lot more interconnected, which is why pipsqueak Greece had the macro implications that it did.

I wouldn’t say I’m scared, but I have a general anxiety of “something bad” happening in the world. Something I didn’t used to worry about 10 years ago. The risk of contagion is permanently higher.

The trading implications are that those upside VIX calls that people always waste money on might not be such a waste of money, probabilistically speaking. Shorter: tail risk might actually be underpriced.

I’m kind of disappointed with our profession, and humans as a species. What is it about the road to hell being paved with good intentions? When we intervene in places we don’t understand, we always do the exact opposite of what we intended to do. Our efforts to “fix” the financial system have actually made it worse.

Imagine that.

Jared Dillian

If you enjoyed Jared's article, you can sign up for The 10th Man, a free weekly letter, at mauldineconomics.com. Follow Jared on Twitter ;@dailydirtnap

The article The 10th Man: Floor Monkeys and Decentralization of Risk was originally published at mauldineconomics.com.
John Mauldin Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules