The Risk of Contagion is Permanently Higher

I wouldn’t say I’m scared, but I have a general anxiety of “something bad” happening.

By Jared Dillian, Mauldin Economics:

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.

By 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.

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  14 comments for “The Risk of Contagion is Permanently Higher

  1. Bob Miller says:

    I do not own a cell phone, and never will, but it is only because I do not need one. When I was flying for Mobil Oil they installed Loran C in all their aircraft. It was wonderful in the Gulf. The problem was, when it failed, the kids who did not trust dead reasoning got lost. I am glad that Wall Street upgraded. Now if they will only find away to improve on their morals.

    • Bob Miller says:

      I will try again…dead reckoning.

      • john tucker says:

        Bob, are “BM” your real initials? (I am not dead yet.)

        I don’t have a cell phone or GPS either but I have navigated, solo, through jurisdictions such as mouse hole, Cornwall, England, and marketro, Addis Ababa, Ethiopia and chapada diamantina, Bahia, Brazil. My friends around here literally cannot find their way to their own mailbox in the front yard without consulting their technology. I used to be scared to bejeeezus about what is going to happen. But TPTB have managed to kick the can just long enough to give me a decent life and a lot of fantastic memories and I can go now in peace… laughing all the while at what is happening to everyone who used to make such fun of me ….

  2. Julian the Apostate says:

    Interesting observation on the dead reckoning angle Bob. I’ve only had the smart phone for 3 years and it’s handy in many ways. But I still back everything important up with pen and ink. I still have 2 boxes of paper maps and an old household movers guide that I never use but could if I needed them. I still use the Rand McNally trucker’s atlas for planning trips. For deliveries in major cities I have most of the highway system etched in my head. My friend is always nagging me to upgrade to a GPS but I’ve never seen the need. Paper never breaks and costs me usually $10 to upgrade when the new maps come out and they reduce the price of last years to clear them out. “The palest ink is better than the best memory.” -Chinese Proverb

  3. michael says:

    Americans have lost their morale compass and cohesiveness. That is something to fear indeed. We are now a republic without laws.

  4. Dave K says:

    You have every reason to be scared. Of the nine recessions in the last sixty years, only three took longer than six years from the end of the previous one. It’s been six years since the declared “end” of the “Great Recession” and you would have to be willfully blind if you thought another one isn’t coming down the pike sooner rather than later.

    Market fundamentals went pfft awhile ago. Markets are carried by a few stocks and bolstered by Fed policy. Commodity prices are in decline, the strength of the dollar is on the rise because of global economical issues which hurts exports, not that the trade balance wasn’t negative to begin with.

    The whole thing is a house of cards, waiting to topple. On top of that, what happens when the next recession hits? The solution over the last twenty plus years has been for The Fed to lower rates to encourage borrowing but rates are already at historic lows and have barely budged in six years. They want to raise rates but they know they can’t and there is no way they can prevent another recession. What are they going to do, go from ZIRP to NIRP, as has already happened in some countries?

    The global economy has become over leveraged and in the end, math will win out and there is nothing any central bank anywhere can do about it. I can almost guarantee that the next financial crisis will be “the big one” and it will make “The Great Recession” seem like a Sunday picnic.

    • Cashboy says:

      I think it is every 7 years that there is a financial crisis.
      I read about Shemitah and this similarly occurs every 7 years.
      So we are due a large financial event in 2015 on that basis and 2015 is the golden year of Shemitah (49 years) so should theoretically be a big one.
      Lets see if this is correct or if it is bu11 sh1t.

    • Jerry Bear says:

      thus I fear our current American Empire will die. Not with a bang, not even with a whimper, but rather a “Duh!” of gross stupidity……..

  5. ML says:

    Essentially, the author of this article is lacking emotional self-confidence. In other words, if you cannot withsrand the heat then get out of the kitchen.

    • margsview says:

      Famous last words, for someone ‘slightly’ ill-informed or buying into all that is. Here, is a fools interpretation of fully understanding, just how heated the kitchen really is!
      IMF advisers have been trying to get hedge fund owners to do some major write-downs on their o/s derivatives (now, the IMF says total 700 trillion globally). This level of freaky junk sold by owners who have demanded and gotten rewarded with a base tax rate of 15%—And to the soon to be dismay of bank customers—-these owners are given ‘preferred creditor-status.

      Explain please, because for the last decade, no one has fully, or often enough, —-in the mass media.
      Oh, and for some more fun, the TISA, Trade in Services Agreement, allows corporations to use this public crusher deal, to privatize all services and programs taxpayers have paid for —-Including (like the Greeks) their public pensions. All done under a 5 year non-disclosure clause against any public being informed as to its actual contents.
      So, that translates into no more public pensions, education, healthcare, insurance, water or any other protected resource. Doesn’t say much for all of this bogus ‘climate change’ jargon?……Or maybe its just like all the b s that has been liberally tossed over the last 18 months on the so-called US ‘recovery’?

  6. margsview says:

    See bilaterals.org for all details and analysis on every global trade deal—comments are welcome too.

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