10/03/2011 - 00:00

Flash crash likely when markets team up

10/03/2011 - 00:00

Bookmark

Save articles for future reference.

Asset correlation has already produced some unintended consequences – and there will be more.

WHAT happens after the world’s financial markets are linked, stock exchanges merge into one giant electronic trading floor, and the values of all asset classes are closely correlated – world peace, or chaos?

The question is so big that some readers will wonder why anybody bothers to ask it, but others will recognise that we are heading rapidly to a point that might be called a single global marketplace.

Stock exchange mergers are a clue. London wants to mate with Canada. Singapore is keen to acquire the ASX. Germany is chasing New York.

High-speed electronic asset trading using complex mathematical formulas (algorithms), which can ram through thousands of deals a second, are already being used; and getting faster.

Money flows at lightning speed from one asset class to another as computers chase a marginal advantage – probing opportunities in obscure assets and looking for answers to questions such as:

• Is there a better return available from owning silver or gold?

• Is cocoa a better commodity bet than copper?

• Is real estate in Australia generating a higher return than Florida orange juice?

Those three examples, as bizarre as they sound, are what asset correlation is all about, a world where “everything is linked to everything else” – an observation made famous by one of the founders of communism, Vladimir Lenin, though he was probably thinking more about human linkages than financial markets.

Whatever dear old Vlad had in mind, the point is that a “correlation of 1.0”, where everything is perfectly linked and evenly valued, might actually be a very dangerous time, as recent academic analyses have concluded.

What’s happened to trigger this deep thinking about the meaning of markets moving together is an attempt to understand the so-called ‘flash crash’ of May 6 last year when trading in an obscure Chicago Board of Trade derivative product caused the biggest ever fall on the New York Stock Exchange.

There was plenty of blame dished out to try and explain the flash crash, which, fortunately, was soon corrected.

High frequency trades (HFT) were singled out as the biggest factor because of the way computers executing those millisecond trades have grown to dominate daily market business.

As if to prove the point, perhaps because of HFT, the world cocoa market collapsed, briefly, last week with the main contract falling by 12.5 per cent in a minute on March 1.

The explanation for the cocoa crash was that a single large sell order triggered ‘automatic stops’, or orders to sell, which drove the market through the floor almost instantaneously. Unravelling the cocoa mess required the cancellation of all trades below $US3,400/tonne.

But, and this is critical, even after pointing a finger at HFT, and unexpected sell orders, the experts examining last May’s Chicago/New York flash crash cannot explain precisely why it happened, leaving open the question: can it happen again?

The obvious answer is yes, it can, and probably will happen again because HFT is penetrating deeper into global markets, those global markets are merging, and ever-more-complex algorithms are being written to link asset classes.

The rationale behind this linking of asset classes and HFT across the world’s exchanges is that, when a perfect correlation of asset values is achieved, risk will be at its lowest.

The problem with that assumption is that not everyone agrees that the game of seeking a common valuation system, or seeking investment proxies, actually works.

An example close to home is the heavy trade in the Australian dollar because international investors see the Aussie currency as a proxy for investing directly in China, without the risks associated with such a move.

What happens when/if China hits a pothole on its high-speed dash to world domination? Easy answer, the Australian dollar falls in a hole, with the national economy not far behind as the cost of borrowing to pay for our lavish lifestyle goes through the roof.

The deepest concern, being expressed by some academics and central bankers, is that a move towards a global correlation of asset values increases, not decreases, the risk of a major price correction.

The silver market is perhaps the best example of what can happen when there is a wholesale stampede into an asset class because it is perceived as representing an arbitrage (price difference) opportunity.

Speculators holding an estimated 15,000t of silver in exchange-traded funds, and investment banks using their HFT capacity, have poured into silver, destabilising the historical linkage between gold and silver, and potentially setting the scene for a catastrophic correction (fall) if/when too many ‘silver bets’ are unwound at once.

Elizabeth MacBride, writing in RIAbiz (a US website for investment advisers) and reproduced in Forbes magazine, summed up her report on the Chicago/New York flash crash with this comment.

“The point is that this convergence of market exchanges, correlation, technologies, regulations and alterations in central bank decisions, and unforseen geopolitical events could take us in directions we never imagined, and at breakneck speeds.”

Welcome to the brave new world of correlation where cocoa, copper, orange juice and exotic financial derivatives merge into one global market – and we wait for the next flash crash.

On the money?

INTERESTINGLY, there is another item of correlated asset values being talked about in global markets, and it is closer to home than you might realise.

Australian property prices are worrying some investors who believe we are set for a big fall because of the ratio of rental income to the value of a property. One estimate is that Australian property is more than 50 per cent over-valued when the rent ratio is applied.

Working against the rent ratio are Australia’s booming terms of trade, another ratio that looks at the value of exports over imports. By that measure perhaps our property market is not so over-valued.

In fact, one recent study showed that a 10 per cent improvement in the terms of trade (and they are now at their best in 60 years) boosts property prices by 5 per cent – meaning that Australian property might actually be close to fair value after all.

 



“Judge a man by his questions rather than his answers.”

Voltaire

 

STANDING BY BUSINESS. TRUSTED BY BUSINESS.

Subscription Options