Best of the Week
Most Popular
1. Investing in a Bubble Mania Stock Market Trending Towards Financial Crisis 2.0 CRASH! - 9th Sep 21
2.Tech Stocks Bubble Valuations 2000 vs 2021 - 25th Sep 21
3.Stock Market FOMO Going into Crash Season - 8th Oct 21
4.Stock Market FOMO Hits September Brick Wall - Evergrande China's Lehman's Moment - 22nd Sep 21
5.Crypto Bubble BURSTS! BTC, ETH, XRP CRASH! NiceHash Seizes Funds on Account Halting ALL Withdrawals! - 19th May 21
6.How to Protect Your Self From a Stock Market CRASH / Bear Market? - 14th Oct 21
7.AI Stocks Portfolio Buying and Selling Levels Going Into Market Correction - 11th Oct 21
8.Why Silver Price Could Crash by 20%! - 5th Oct 21
9.Powell: Inflation Might Not Be Transitory, After All - 3rd Oct 21
10.Global Stock Markets Topped 60 Days Before the US Stocks Peaked - 23rd Sep 21
Last 7 days
S&P 500 – Is a 5% Correction Enough? - 6th Dec 21
Global Stock Markets It’s Do-Or-Die Time - 6th Dec 21
Hawks Triumph, Doves Lose, Gold Bulls Cry! - 6th Dec 21
How Stock Investors Can Cash in on President Biden’s new Climate Plan - 6th Dec 21
The Lithium Tech That Could Send The EV Boom Into Overdrive - 6th Dec 21
How Stagflation Effects Stocks - 5th Dec 21
Bitcoin FLASH CRASH! Cryptos Blood Bath as Exchanges Run Stops, An Early Christmas Present for Some? - 5th Dec 21
TESCO Pre Omicron Panic Christmas Decorations Festive Shop 2021 - 5th Dec 21
Dow Stock Market Trend Forecast Into Mid 2022 - 4th Dec 21
INVESTING LESSON - Give your Portfolio Some Breathing Space - 4th Dec 21
Don’t Get Yourself Into a Bull Trap With Gold - 4th Dec 21
GOLD HAS LOTS OF POTENTIAL DOWNSIDE - 4th Dec 21
4 Tips To Help You Take Better Care Of Your Personal Finances- 4th Dec 21
What Is A Golden Cross Pattern In Trading? - 4th Dec 21
Bitcoin Price TRIGGER for Accumulating Into Alt Coins for 2022 Price Explosion - Part 2 - 3rd Dec 21
Stock Market Major Turning Point Taking Place - 3rd Dec 21
The Masters of the Universe and Gold - 3rd Dec 21
This simple Stock Market mindset shift could help you make millions - 3rd Dec 21
Will the Glasgow Summit (COP26) Affect Energy Prices? - 3rd Dec 21
Peloton 35% CRASH a Lesson of What Happens When One Over Pays for a Loss Making Growth Stock - 1st Dec 21
Stock Market Sentiment Speaks: I Fear For Retirees For The Next 20 Years - 1st Dec 21 t
Will the Anointed Finanical Experts Get It Wrong Again? - 1st Dec 21
Main Differences Between the UK and Canadian Gaming Markets - 1st Dec 21
Bitcoin Price TRIGGER for Accumulating Into Alt Coins for 2022 Price Explosion - 30th Nov 21
Omicron Covid Wave 4 Impact on Financial Markets - 30th Nov 21
Can You Hear It? That’s the Crowd Booing Gold’s Downturn - 30th Nov 21
Economic and Market Impacts of Omicron Strain Covid 4th Wave - 30th Nov 21
Stock Market Historical Trends Suggest A Strengthening Bullish Trend In December - 30th Nov 21
Crypto Market Analysis: What Trading Will Look Like in 2022 for Novice and Veteran Traders? - 30th Nov 21
Best Stocks for Investing to Profit form the Metaverse and Get Rich - 29th Nov 21
Should You Invest In Real Estate In 2021? - 29th Nov 21
Silver Long-term Trend Analysis - 28th Nov 21
Silver Mining Stocks Fundamentals - 28th Nov 21
Crude Oil Didn’t Like Thanksgiving Turkey This Year - 28th Nov 21
Sheffield First Snow Winter 2021 - Snowballs and Snowmen Fun - 28th Nov 21
Stock Market Investing LESSON - Buying Value - 27th Nov 21
Corsair MP600 NVME M.2 SSD 66% Performance Loss After 6 Months of Use - Benchmark Tests - 27th Nov 21

Market Oracle FREE Newsletter

How to Protect your Wealth by Investing in AI Tech Stocks

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