A new world order

As regulators probe whether market participants have learnt lessons from the financial crisis, Declan McEvoy suggests all may not be as it seems…

If we mark the fall of Lehman Brothers as the epicentre of the financial crisis, there have been many structural changes to the markets since then.

Since then, there has been continued growth in buy-side assets under management and the collapse of sell-side willingness to make markets.

The have been much higher capital requirements on sell-side banks – meaning they have to allocate capital internally if they want to hold large positions in longer term bonds – so they have all shrunk or are shrinking their balance sheets.

Central Bank reliance

This has taken place against a backdrop of virtually unlimited liquidity availability from the Central Banks.

In other words, there has been a decent attempt to repair the aeroplane mid-flight.

The interference of the Central Banks has led to large distortions in estimating what the true “clearing” price of many assets really is (or was).

Many players who should have been forced to sell
were effectively saved from having to do so.

So, the summary is that is difficult to assess if global markets, with all these changes, really are “well-functioning”.

Most asset managers have been handsomely rewarded over the past seven years for sticking with a simple buy-and-hold and buy-the-dips strategy.

While markets have experienced periods of risk aversion, the underlying belief that the Central Banks will add yet more liquidity if things start to sag has proven to be correct.

The only evidence of this current situation now being a threat is the reaction function of markets when this unlimited liquidity provision is hinted to be coming to an end.

The conclusion must be that inflation is the real threat – if it were to spike higher and remain elevated for some reason, the Central Bankers’ convenient excuse for untrammelled liquidity provision would cease – and then we would witness what the buy-side can actually do in a difficult environment.

Higher frequencies

High frequency trading is experienced by non-HFT market participants in much the same way as scientists at CERN (European Organisation for Nuclear Research) observe sub-atomic particles.

High frequency traders are in the game to make money (isn’t everyone) but the main fallacy that they try to peddle is that they take risk and add liquidity.

Michael Lewis’s book – Flash Boys – brilliantly documented how they make money – they use their speed advantages to front-run everyone and their knowledge of how big asset managers send orders to market to identify the steam rollers coming way in advance.

By definition, adding liquidity implies that someone is a willing buyer where everyone else is looking to sell and a willing seller when everyone else is looking to buy. They slow the price momentum down by their actions. The much-maligned proprietary trading desks at the big banks (now mostly shuttered) used to perform this function very effectively .

Sure, they were in the game to make money too, but they were also willing to take the other side of a market and hold that position for days, weeks or months.

HFTs provide no such buffer – they have super low holding periods and never seek to commit capital for any length of time.

Market participants know all of this – the anti-HFT narrative is really just other market commentators coming to grips with what their true nature actually is...

The biggest buy-side firms – such as BlackRock – are super-sophisticated liquidity-provision machines. It nets everything internally

If one manager wants to sell and one wants to buy, they will do that. They will only go to market when they have to.

Larger buy-side firms also have plugged themselves in to the sell-side very effectively too, using dark pools and daily ‘runs’ in bonds (what’s for sale and what’s bid) with the best of them.

The liquidity division between buy-side and sell-side is therefore more blurred than ever before.

Declan McEvoy is founder and chief executive officer of Coalface Capital