Best of the Week
Most Popular
1. Next Financial Crisis Is Already Here! John Lewis 99% Profits CRASH - Retail Sector Collapse - Nadeem_Walayat
2.Why Is Apple Giving This Tiny Stock A $900 Million Opportunity? - James Burgess
3.Gold Price Trend Analysis - - Nadeem_Walayatt
4.The Beginning of the End of the Dollar - Richard_Mills
5.Stock Market Trend Forecast Update - - Nadeem_Walayat
6.Hindenburg Omen & Consumer Confidence: More Signs of Stock Market Trouble in 2019 - Troy_Bombardia
7.Precious Metals Sector: It’s 2013 All Over Again - P_Radomski_CFA
8.Central Banks Have Gone Rogue, Putting Us All at Risk - Ellen_Brown
9.Gold Stocks Forced Capitulation - Zeal_LLC
10.The Post Bubble Market Contraction Thesis Receives Validation - Plunger
Last 7 days
2019’s Hottest Commodity Is About To Explode - 15th Oct 18
Keep A Proper Perspective About Stock Market Recent Move - 15th Oct 18
Is the Stocks Bull Dead? - 15th Oct 18
Stock Market Bottoms are a Process - 15th Oct 18
Fed is Doing More Than Just Raising Rates - 14th Oct 18
Stock Markets Last Cheap Sector - Gold - 14th Oct 18
Next Points for Crude Oil Bears - 13th Oct 18
Stock Market Crash: Time to Buy Stocks? - 12th Oct 18
Sheffield Best Secondary School Clusters for 2018-19 Place Applications - 12th Oct 18
Trump’s Tariffs Echo US Trade Policy That Led to the Great Depression - 12th Oct 18
US Dollar Engulfing Bearish Pattern Warns Of Dollar Weakness - 12th Oct 18
Stock Market Storm Crash, Dow Plunges to Trend Forecast! - 12th Oct 18
SP500 Stock Market Sell Off Well Forecast by President Trump - 11th Oct 18
USD and US Tr. Yields Retreat, GBP Gains on Brexit-deal Report - 11th Oct 18
Loss Of Yield Curve "Shock Absorber" Could Mean A Rough Ride Ahead For Markets & Housing - 11th Oct 18
Just How Bearish is the Stock Market’s Breadth? - 11th Oct 18
Here’s Why Gold Stocks, Gold, and Silver Are Great Buys Now - 10th Oct 18
Russian Ruble Technical Chart Analysis and Forecast - 10th Oct 18
Society Trends To Keep in Mind in the USA - 10th Oct 18
[eBook] How to Identify Turning Points in the Market - 10th Oct 18
Euro Vulnerable as Slowing Growth Reveals Underlying Issues - 9th Oct 18
Construction Companies to Watch For in 2019 - 9th Oct 18
ECB Meeting Minutes and US Inflation Data in Focus - 9th Oct 18
Interest Rate Shock-Time to Find Out Who has been Swimming Naked - 9th Oct 18
Unintended Consequences of Expanding Sheffield's Best Ranking State Secondary Schools - 9th Oct 18
Crude Oil Price Trend Forecast 2018 Update - 9th Oct 18
Inflation Is Starting To Heat Up - 8th Oct 18
Stock Market Seasonal Influence at Work - 8th Oct 18
Barrick Randgold Deal Breathes New Life into Gold - 8th Oct 18
Stock Market Sell Off, Dollar Rally Expected, Now What? - 8th Oct 18
The Chartology of Gold and Silver - 8th Oct 18
The Income for Life Playbook - 8th Oct 18

Market Oracle FREE Newsletter

Trading Any Market

The Unanticipated Consequences of Purposive Social Action

InvestorEducation / Learn to Trade Jan 08, 2015 - 05:57 PM GMT

By: John_Mauldin

InvestorEducation

Pretend you are a corn trader. As such, you have two choices: have a position in corn futures or own physical corn.

It may seem silly to even consider owning physical corn, because corn futures are easy to trade—just click a button on your screen. But assume you have a grain elevator, and whether you own futures or physical corn is all the same to you. How do you decide which you prefer?


If one is mispriced relative to the other.

If you consider owning physical corn, you have to take into account the cost of storage and any transportation costs you may incur getting the corn to the delivery point. You also have to think of the cost of carrying that physical corn position, or the opportunity loss you incur by not investing the money in the risk-free alternative.

The thing is, there’s nothing keeping the spot and futures markets on parallel tracks, aside from the basis traders who spend their time watching when the futures get out of whack from the physical.

That basis exists in just about every futures market, even in financial futures that are cash-settled. In fact, that was pretty much my life when I was doing index arbitrage—trading S&P 500 futures against the underlying stocks. I was basically a fancy version of the basis trader in corn.

With stock index futures (like the S&P 500, or the NDX, or the Dow), the basis is slightly more complicated. Not only do you have to calculate the cost of carry—which is usually determined by risk-free interest rates and the stock loan market for the underlying securities—but you also have to take into account the dividends that the underlying stocks pay out. Remember, futures don’t pay dividends, but stocks do. At Lehman Brothers, we had a guy whose sole job was to construct and maintain a dividend prediction model for the S&P 500.

So far, so good. However, one of the first things I learned about on the index arbitrage desk was EFP, which stands for Exchange for Physical—a corner of the market almost nobody knows about.

Basically, we could take a futures position and exchange it for a stock position at an agreed-upon basis with another bank or broker. Interdealer brokers helped arrange these EFP trades. The reason so few people know about them is probably because, historically, the EFP market has been very sleepy. The most it would usually move in a day was 15 or 20 cents in the index, or in interest rate terms, a few basis points.

Now it is moving several dollars at a time.

A Basis Gone Berserk

Back when I was doing this about ten-plus years ago, we had a balance sheet of about $8 billion, which is to say that we carried a hedged position of stocks versus S&P 500 futures (also Russell 2000 futures, NASDAQ futures, etc.).

We did this for a few reasons. One, it was profitable to do so—the basis often traded rich so that by selling futures and buying stock and holding the position until expiration, we would make money. Also, by carrying this long stock inventory, we were able to offset short positions elsewhere in the firm and reduce the firm’s cost of funds. At Lehman and most other Wall Street firms, index arbitrage was a joint venture with equity finance.

During the tech bubble in 1999, the basis got very, very rich because money was plowing into mutual funds and managers were being forced to hold futures for a period of time until they were able to pick individual stocks.

During the bear market in 2008, the basis traded very cheap, up until very recently, because inflows into equity mutual funds were weak, and index arbitrage desks were willing to accept less profit on their balance sheet positions.

But now, the basis has gone nuts.

It always goes a little nuts toward year-end because banks try to take down positions to improve the optics of their accounting ratios. If you have fewer assets, your return on assets looks better. So when banks try to get rid of stock inventory into year-end, they buy futures and sell stock, pushing up the basis.

But now it has skyrocketed, and the cause seems to be the effects of regulation.

We’ve talked about this before, in reference to corporate bonds. Banks aren’t keeping a lot of inventory anymore, because there’s no money in it. The culprits here are a combination of Dodd-Frank and Basel III. There are all kinds of unintended consequences, and the EFP market going nuts is probably the least of it.

But even that is a big one. Basically, it has introduced significant costs (about 1.5% annually) to the holder of a long futures position, which includes everyone from indexers all the way down to retail investors. These are the sorts of things that don’t get talked about in congressional hearings. Did XYZ law work? Sure it worked. But now it costs you 1.5% a year to hold S&P 500 futures and roll them, and you can’t get a bid for more than $2 million in a liquid corporate bond issue.

It’s All About Liquidity

The liquidity issue is the biggest one, and the one I harp on all the time. Pre-Dodd-Frank, the major investment banks were giant pools of liquidity. You wanted to do a block trade of 20 million shares? No problem. You wanted to trade $250 million of double-old tens? It could be done.

Not anymore. Liquidity has diminished in just about every asset class, from FX to equities to rates to corporates, because compliance costs have gone up and it’s expensive to hold more capital against these positions. Someday, someone might take up the slack, like second-tier brokers or even hedge funds.

But here’s the biggest consequence of the equity finance market blowing up: High-frequency trading (HFT) firms that aren’t self-clearing now find it difficult to trade profitably and stay in business. With fewer of them around, we will finally get an answer to the question whether they add to liquidity or not.

So if you talk to an index arbitrage trader about what is going on with the EFP market, he can tell you precisely why it is screwed up. It’s an open secret on Wall Street. Introduce a regulation over here, an unintended consequence pops up over there. Then there are more regulations to deal with the unintended consequences. Regulations have added 100 times the volatility to one of the most liquid and ordinary derivatives in the world—the plain-vanilla EFP.

Less liquidity, more volatility—welcome to 2015.

Jared Dillian

The article The 10th Man: EFPs and The Unanticipated Consequences of Purposive Social Action was originally published at mauldineconomics.com.
John Mauldin Archive

© 2005-2018 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