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 letís 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. Letís 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 isnít going to take out the exchange. Even a handful of traders arenít 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 todayówhere we take small risk and turn it into big risk.
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.
Itís whatís turned the NYSE from a bustling marketplace into a glorified TV studio. Itís what turned the AMEX, the old curb exchange, intoÖ 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.
Iíll 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 itóhuman or computer. For a number of reasons, Iíd 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 riskóthey are in and out of it very quickly, so itís unlikely that theyíd 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 againóeven bigger?
These scenarios are very unlikely, but it doesnít change the fact that we are centralizing risk, rather than decentralizing it. Not good.
Itís 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 onóthat states and municipalities retain political control.
Problem is, weíve been concentrating risk everywhere since the financial crisis. I donít 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 donít think thatís progress. I donít think itís progress that if anything goes wrong, we put it on the governmentís balance sheet.
If I were in a position of authority in the government, Iíd spend my time looking for ways to break down risk to the smallest unit possible.
But thatís not what weíre doing. Weíre 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%.
Iím not trying to say something splashy. Itís 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 isnít with the ETF. Itís with the stupid regulations that constrain bond dealers from doing their job. Icahn is wrong.
Remember the Long-Term Capital Management crisis in 1998? Pretty good example of risk getting centralized.
But hereís the scary thing. That whole crisis was over seven billion dollars. Seven billion lousy dollars. Amaranth lost almost that much and didnít even flinch. For Bridgewater, thatís 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 wouldnít say Iím scared, but I have a general anxiety of ďsomething badĒ happening in the world. Something I didnít 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.
Iím 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 donít understand, we always do the exact opposite of what we intended to do. Our efforts to ďfixĒ the financial system have actually made it worse.
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