Value at Risk, Equity Market Volatility is All About Liquidity

First a note from the cookie factory. Preliminary ratings for Q1 2010 for US banking institutions from the professional version of The IRA Bank Monitor are rolling in at a good pace. With 7,240 bank units reporting, the preliminary aggregate Stress Index rating is currently just 5 vs. 21.5 in Q4 2009. This suggests that the US banking industry is officially on the mend in terms of building reserves, but the credit cleanup continues even as new events climb over the horizon. Click here to see our post about the BSI results on ZeroHedge.

For example, last week the global financial markets went for a wild ride, but that is what happens in a mostly free marketplace that sees national insolvency all around. You can blame last Thursday's market collapse on the unhappy creditors of the members of the Euro federation, or the equally tortured and loathed program traders, but the multiple loosely connected execution venues for the same NYSE listed stock worked as planned -- and that fact lies at the heart of the perceived problem last week. We don't see a problem. The system worked. The problem was a lack of investors.

In a sense Thursday proves that we all got our wish. The market unity mandated by Congress in the National Market System (NMS) that is now governed by the SEC's Regulation NMS, wired together the heretofore fragmented collection of exchanges around the US and, now, around the world.

With the adoption of Regulation NMS, we essentially created a virtual exchange for all of the regional and electronic executions systems globally, which reflect the trading activity of all of their constituents. Whereas in the past it was possible to execute trades at prices different from those on the NYSE on disparate exchanges without affecting the Dow and other major indices, now these different venues all feed prices into the NMS. The system works.

The problem revealed last Thursday was what happens to prices when the NYSE briefly stopped trading in certain names. Unfortunately, the innovative alternative trading platforms that have been allowed to sprout in the name of competition ignored the NYSE trading halt. The result was an effective "zero bid" for some blue chip names, making large caps into penny stocks in terms of the available liquidity. But these stocks continued to effect the performance of the major indices, unlike in the pre-NMS days when they might not have been reflected -- at least not immediately.

The folks at the SEC and FINRA somehow convinced themselves, all in the name of competition and efficiency, that these other execution arenas need not follow the lead of the NYSE's market surveillance function. It strikes us that if you accept the concept of circuit breakers, then the public spanking for the NYSE and SEC, etc. on Thursday will help us to require that all secondary markets must halt trading when the primary listing market decides to slow down the music. Otherwise we say get rid of the politically motivated circuit breakers entirely and let the market trade.

Another big culprit, we hear from a colleague in the world of equity operations, was the fact that the market already was down 300 points at midday, making the subsequent drop all the more profound when the NYSE took these stocks offline for a 90 second pause. The veteran risk officer says that many of the high frequency trading (HFT) outfits and quant shops turned off their algorithmic traders or "algos."

A lack of algos means there were far fewer counterparties willing to step in to the other side of the trade, resulting in the large gaps downward as sellers looked for bids. So while many seem attractive to politicians and pundits to bash the HFTs as the source of the market unease, it was their absence which exacerbated the gaps down on Thursday.

The other thing to bear in mind is that while we are all conditioned to believe that markets are efficient and continuous, Thursday proves otherwise. We are reminded by another market participant that every trade on Thursday had two sides:

"Someone wanted to sell Accenture for a penny, as foolish and stupid as it might be. So if they didn't want to do such, they should have checked their order systems better. Fools. Recall this downdraft continued for 15 minutes. There were people who wanted to trade out at any price, and they got what they deserved. This wasn't a fat finger or bad algos gone wild. This was an emotional market exacerbated by a bunch of people stepping to the sidelines."

The talking heads on CNBC and other media can say what they want about external factors at work last Thursday, but the fact is that the system worked as it is supposed to and the lacking was in market confidence and liquidity. Just as Buy Side investors don't like to see ratings change too quickly, politicians get queasy when the Dow moves 1,000 points in a day.

Emotional or not, the trading action of Thursday reminds us that the global equity markets are still comprised of real people and real firms with capital at risk. We once thought we had a global market in residential mortgages, recall? What we had last week was a reminder of the huge uncertainty that remains in markets today, uncertainty that produced a liquidity driven downdraft in prices for some very large cap names.

More significantly, the change in the market's expectations regarding volatility is making some players step back from the markets. That is the heart of the liquidity problem. But since professionals in the form of funds and dealers are the only ones in the US equity markets by and large, we expect to see this type of volatility continue.

One of the big drivers of the equity volatility is the Fed's zero rate policy, which is forcing investors to search for yield in some very strange places. Once again, we call on our friends at the Federal Reserve Board to let interest rates slowly start to rise before this situation gets entirely out of hand -- again. As we said at the top of this comment, the banks are on the mend. Time to find out whether the US economy can grow with positive real interest rates.