Speed is good
Richard Olsen argues that, far from slowing down, transaction volumes need to increase by a factor of thousands, and that pension funds should benefit from its uncorrelated alpha
Today’s financial markets are dysfunctional - price movements are exaggerated and do not mirror underlying fundamentals. The cause is a lack of market liquidity across time scales. We need to dramatically increase liquidity in financial markets by allocating high-volume investment strategies that inject liquidity and contribute to price stability.
The returns generated by these strategies are a reward for providing liquidity and contributing to price stability, thereby increasing the efficiency of the economy as a whole. Long-term investors, such as pension funds, are ideally suited as sponsors. They have a vested interest in the long-term health of the economy and can afford to weather short-term drawdowns, as long as they receive a mid-term appropriate reward. This recommendation proposes an efficient alternative to the current political desire to argue for a slowdown of trading, even to the point of imposing a tax on financial transactions.
The science of global economics has developed its theories using powerful computers with access to large amounts of tick-by-tick market data. This has dramatically changed their understanding of the mechanics of markets.
The impact of these discoveries is comparable to what happened in physics at the start of the last century, when physicists were able to observe matter at an atomic scale, revolutionising their understanding of the dynamic properties of matter.
Financial markets, and the economy as a whole, are dynamic systems where everything is in motion. The economic system is comparable to the human body, which is a dynamic system. In our everyday life we fail to appreciate that the heart pumps five litres of blood every minute to transport fresh oxygen to the cells and remove toxic waste without big disequilibria building up. In just 12-16 minutes, the heart pumps as much blood as the human body weighs. It does this an astounding 100 times a day.
In financial markets, the volume of transactions is a mere trickle compared with the blood circulation of the human body. In the foreign exchange market, which is roughly 10 times bigger than the second biggest market, the bond market, the daily spot FX transaction volume is $1.4trn (€1.13trn), or 2% of the world’s annual product. If world annual product is a proxy for the body’s weight, the rate of human blood circulation is a factor of 5,000 times larger than that of FX. Even though the face value of $1.4trn seems large, it is small when compared with a dynamic system like the human body.
That $1.4trn, divided over 86,400 seconds, equates to a second-by-second transaction volume of just $8m of buying and $8m of selling for the whole FX market. For EUR/USD it is approximately $4m of buying and $4m of selling; and just $300,000 for minor exchange rates such as USD/GBP. If one trader buys EUR/USD for $100m, the trader swamps the market and accounts for the average volume of a full 25 seconds.
Because the second-by-second transaction volume is so low, any unexpected market order from anywhere around the world can trigger a price spike. In liquid markets, the positions of market participants are marked to market with every new price tick. A new price tick in the adverse direction can trigger margin calls; the positions are closed out. A closure of positions increases the imbalance of buying and selling even more and fuels a continuation of the price move, leading to further margin calls.
Research has shown that cascading margin calls have a price impact far beyond the short term; they can influence the price trajectory over months and years. The explanation is intuitive: overconfidence of traders is most likely in the direction that fundamentals favour. Cascading margin calls are therefore more likely in the opposite direction to the fundamentals. The margin calls deplete the equity base of traders betting in the direction of the fundamentals and reduces their buying power, shifting the balance of buyers and sellers and changing the long-term price trend. The resilience of the euro to all the bad news over the past two years is an example of the impact of this mechanism.
If the imbalance between buying and selling volume exceeds a critical threshold, then the price impact is disproportionate. A striking example is the flash crash in 2010, when the US stock market dropped by close to 10% within minutes. At smaller scales, this is an everyday occurrence.
To prevent unnecessary overshooting, imbalances between buyers and sellers need to stay small. Quantitative investment strategies can contribute to this objective - they are fully-automated algorithms with so-called virtual traders for short to long-term time scales that wait on the sidelines for price overshoots due to significant imbalances of buying and selling. They enter into counter-trend positions to provide temporary liquidity and close their position as soon as the market has stabilised again. An established trading strategy with a live track record generates approximately 2% of return with 2% risk without leverage or, packaged as a hedge fund product, around 10% of return per year with 8% annualised volatility.
At the core of every liquid market, there is the destabilising force of cascading margin calls. There is the need for a counter-force. We take it for granted that the market can provide such a force: this is often not the case. The stabilising investment strategies are a solution with a well-controlled process. Pension funds are the ideal sponsors; and they would be rewarded with a return that is uncorrelated with literally any other investment product or asset class.
Today, in the confines of the established regulatory framework, pension fund managers are allowed to allocate to such strategies on a funded and unfunded basis. Medium-term, the regulatory framework has to be enhanced to allow pension funds to allocate far larger amounts of capital to such strategies than is feasible today.
If we use blood circulation in the human body as a benchmark, transaction volumes need to increase by a factor of 5,000 to achieve an optimum. For the science of global economics, generating performance by contributing to economic stability is as important as making so-called productive investments into property and shares. Without sufficient blood circulation there is no human life. Similarly, the economic system needs market-stabilising investment strategies to function properly.
Richard Olsen is founder of Olsen Ltd and a visiting professor at the Centre for Computational Finance and Economic Agents at the University of Essex