The Truth About Market Crashes, Liquidity and “Evil Speculators” by Professor Mark Merlin

Watching this video of the May 6 Flash Crash (http://bit.ly/iuwk9X) it’s hard not to make some critical linkages to today’s world where “evil speculators” in the futures markets are often the first to receive blame when any negative market event hits voter’s wallets. The issue doesn’t seem to matter – from rising gasoline prices to plummeting stock prices – the simple solution is to gang up on the financial industry that is least understood.

Consider the liquidity-based “flash crash.” After the event, opportunistic individuals were first to blame the futures markets. Politicians demanded market information from regulators and exchanges as they sharpened their political knives, preparing to vilify an industry. But the futures industry – the CFTC and primary exchanges – were the first to produce valuable data on trading that day. The data requested, and the ability to produce, highlighted the efficiency of the systems and procedures in place, structures that are too often overlooked. While politicians picked on the first available target, those who understand the underpinnings of financial markets studied liquidity in search of a smoking gun.

Follow the Liquidity

While mountains of reports have been written about the flash crash, the crash video from the CME floor remains an interesting testament to the liquidity in the futures markets – and the value speculators provide to the markets.
As equity prices were in free fall — and Accenture investors, for instance, watched their stock value drop from the $40 range to relatively worthless in a matter of minutes — the S&P 500 futures pit remained reasonably liquid. While the price rightly dropped, generally both buyers and sellers were actively making two-sided making markets throughout the crash. Only for one brief moment, at the height of the panic, did the bid-ask spread reach wide levels, but there were nonetheless both buyers and sellers participating, which is the critical point: even as equity markets panicked, futures traders were still willing to step in to help make two sided markets until the panic subsided.

During the flash crash, the open and regulated financial markets were doing nothing more than providing an accurate reflection of the turmoil at a given moment in time. Understanding this primary price discovery function of a market is to recognize the benefit of a regulated and transparent exchange traded dynamic.

To provide a real estate analogy of how price discovery properly works as values and economic fortunes inevitably shift, consider how a home built in a flood plain may have a different fair value – and different risk management needs – than a home located on historically high ground. Now consider what happens to a potential home buyer and seller when long term forecasts indicate the flood plain may experience abnormally high rain? The person in the flood plain may experience a crash in the value of their house. The market has no opinion on price, and the crash isn’t the fault of the real estate market, but rather the economic reality.

Now consider what happens in this real estate transaction if only the seller had possession of the news of pending rain. Does the person who possess the information on rain have an undue benefit? If it were an open and transparent futures market, the price of the asset would reflect the latest news. The price of the house would reflect the news when the buyer of the house wouldn’t necessarily be aware of the news. The house price could plunge on the open futures market, having a negative impact on the home owner. If it were on a regulated futures market, even though the home buyer may not have access to the information, the home price would be re-valued to a more accurate and fair market price, with both buyer and seller having equal access to fair value at a given moment in time.

Both the buyer and seller need to take all the available information into consideration when determining a fair price, which is what a futures market does both positive and negative. Higher prices are not caused by this process of investigation, known as price discovery. It is the underlying information that this type of investigation uncovers that is the result of price discovery, not the cause. At least in an open and regulated futures exchange both buyer and seller are aware of the adjusted price, which is reflective of all information available to the market. Even though the news may be negative, at least market participants are aware of the value.

To consider how harmful not knowing the marked-to-the-market value of an asset can be, consider the unregulated mortgage backed derivatives that imploded in 2008. Turn to page 92 for a pointed perspective:

“It is interesting to consider what would have happened if non-transparent, unregulated mortgage derivatives were traded on an open and regulated futures exchange. Investors could have seen the value of their asset in real time marked to the market on a daily basis. They might not like what they see… as their financial world crumbled around them. But as an investor it is better to have transparency into an investment, to understand the value of an investment as it is rising and falling, good and bad, than to be surprised and caught flat-footed” as was the case in 2008 during the credit crisis crash.

These thoughts also have meaning relative to the current debate regarding the oil market. While rise in oil prices was nothing more than a reflection of price discovery and the sometimes irrational opinions of market participants and their views on the future price of oil, the markets and industry are nonetheless vilified through rants of “evil speculation” driving the price needlessly higher. However, even the most simplistic analysis of the energy and commodity markets recognizes a world of finite assets and increasing global demand in a geopolitical climate that can only be described as increasingly unstable. It is interesting to note that oil has risen only 26% in price since 1919, while US vehicle ownership has risen 3,250%. The futures markets are based on future assumptions of supply and demand. In part, the rise in oil is a reflection of this common belief among market participants. The market opinions are expressed as buying and selling and sometimes this activity can seem irrational. But one thing is clear:

The worst thing that one could do to an economy would to be to handcuff its ability to respond in a world that processes information at an ever increasing speed. It will be the most agile economy that prospers in the next 100 years, and as such one should not hinder the price discovery process. From one perspective, one could look to price discovery as a barometer of the political and economic effect on a market, which can come to a pointed head during times of crisis.

It could be said the value of a financial market is best on display during times of crisis – just as the value of a commodity trading advisor (CTA) is best on display when the market moves against them. If this is the case, watching a market perform at a high level of efficiency, offering liquidity at the most critical time, is impressive, but unfortunately this effort was nonetheless overlooked by those in the nation’s capital who believe that government can “solve” the problems of a stock market crash or “avoid” the rapidly rising cost of oil by blaming “speculation.”

Is Managed Futures Speculation Evil?

Managed futures is among the investment industries where “evil speculators” are sometimes targeted by those politicians looking for the easy way out. It should be noted that managed futures provides liquidity on both sides of a market and the core performance drivers are not tied to economic supply and demand. As Neil Menard of commodity pool operator Steben notes: “We were long oil on the way up and short oil on the way down. Our industry was blamed when prices rose but didn’t hear a word when prices fell.”

This long/short ability highlights the difference between managed futures and long only commodity ETFs, which can create temporary supply and demand imbalances on markets if they do not wisely time and execute their trades so as to work with market making realities. In fact it should be noted that managed futures offers a significant societal benefit by providing investors a potential safe haven during times of market crisis. This safe haven exists because the core performance drivers in managed futures are very different from the stock market. While risk exists in all investing, managed futures risk is just different from stock market risk.

As government scapegoating targets “speculation,” it is not protecting investors, particularly when such rhetoric could lead to legislation that will in face decrease market liquidity. The question to ask is:

Will those politicians engaging in the scapegoating of “speculation” accept responsibility for their actions if market liquidity dries up during times of crisis? Will investors become dependent on foreign markets during times of crisis? If these developments were to occur, we could see a market crisis of epic proportion.

The unvarnished truth is government cannot prevent market crashes or rising price by toying with liquid markets. Liquidity and honest price discovery is the best a market can offer during times of crisis. Government’s role should be to keep the playing field open, fair and transparent, not to influence the outcome of price discovery or pass judgment on the suitability of investment opinions.

It is impossible to predict the future. But this prophecy is likely to occur to a high degree: Future investors will see other stock market crashes and commodity price surges – they will happen time and time again. But such activity, negative to the wallets of US voters, will not be the fault of the markets. The core fundamentals of economic supply and demand, which drive stock and long only commodity investments, will be the culprit – a more difficult target to blame.

A market is nothing more than a location for price discovery, and to blame a well-functioning market for the price or outcome is rather like shooting the messenger. If government wants to prevent a future stock market crash, the first place to start is by acknowledging the difficult elephant in the room. Fixing the government’s balance sheet, where spiraling spending and plummeting revenue requires politicians to act like adults and make the real difficult decisions that voters might not like but need to accept. These are tough choices without easy solutions, part of why investors have a right to access uncorrelated investments at this moment in history.

Blaming components of the futures markets and its participants for rising oil prices or falling stock prices is a historic political use. But the fact is blaming a market that provides the needed shock absorber during times of crisis does nothing but place our economy at risk by those looking for quick political points. It is a dangerous game, indeed.

CONTENT DISCLOSURE

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Professor Mark Merlin© www.go2managedfutures.com