Welcome to the End of The Trading Era – The Completion Backwards Principal

Over the last few weeks we’ve seen some pretty extraordinary moves in the bond markets. We’ve seen bonds trade over 2-3 percent daily trading ranges – ranges that would be considered extreme a few years ago for such non-volatile core investment instruments. We’ve seen investors increasingly concerned that stock market valuations look overblown, and there are fears that bubbles have developed in many other markets including property. Yet, the fundamental outlook for the global economy is becoming better. We’re even seeing growth and inflation in Europe, a continent that looked likely to be the last that would ever recover.

On one hand we have signs of growth. On the other we have deep seated fear developing with regard to financial assets. Many folk wonder why. As a finance professional, it scares me to think about how increasingly interdependent, complex and vulnerable modern finance has become…

I’ve been commenting on the underlying rationale for market moves and the opportunities they create for many years – since well before the global financial crisis began in 2007. Since the crisis, I’ve focused an increasingly sceptical eye on the cumulative effect of regulatory and fiscal developments across markets.

Like everyone else I’ve noticed how market prices have been increasingly warped by factors such as QE distortions, while more expensive and restrictive regulatory capital and trading rules have changed trading patterns. Today the big fear is that diminished liquidity will make market moves more extreme and volatile. Even central banks are commenting on these dangers. I’d argue most of the liquidity conundrum is due to restrictive capital and trading regulations – although others say it’s temporary because bond markets are at the top and no one wants to position.  

Most bankers won’t comment on regulation. Their employers fear the power of the regulators will come down like a ton of bricks. Daring to question them is seen to be too dangerous. But it’s time to speak up. While regulatory intentions may be laudatory and well intentioned, there is a danger we have missed how large the menacing and over-arching forest of market crushing rules has grown from the regulatory trees that have been planted. The invisible hand of markets is becoming tied up in regulatory red-tape.

My thesis is simple: initially well intentioned over-regulation, market oversight and bureaucracy, stress tests, fiscal games, and controls have become a far more pernicious danger to the global economy and markets than the Global Financial Crisis that spawned them.

It’s a mistake to simply accept each new regulatory imposition as financial “health and safety”. Yet, the public have been persuaded these changes and improvements in financial regulation make the world a safer place. I suspect the consequences are going to be extreme. The last eight years of regulation have certainly not made markets more efficient, and for markets to allocate resources they, by definition, need to be efficient!

The “market-regulatory-complex” – a term I christen to describe the growing nomklematura of regulators, finance-ucrats. central bankers, analysts and other busybodies who now determine how markets works – have been encouraged as a direct result of politicians successfully transferring “market-blame” on to the shoulders of banks. Politicians win votes by being “tough on banking and the causes of banking”. Forget the fact that homeowners want mortgages and credit, and business needs financing – it’s the fault of bankers meeting these needs that caused the crisis.

In many ways regulation has succeeded. Finance has cleaned up its act and many rotten apples have been caught and dealt with. But the narrative has become one of greater oversight, regulation and strict enforcement successfully making global markets fairer and reducing the chances of further market catastrophes. It’s an absolute nonsense and a dangerous lie to sell to electorates.

Over my 30-years in finance, markets have never ever felt so unbalanced, unstable and liable to massive ructions. I’m not so concerned with how stock markets will respond to a likely further dip in oil prices as a result of the next Opec meeting – that’s demand/supply stuff. I’m more worried about the actual structures and functioning of markets.

Let me try to explain my worries.

One example is the role of traders. In the past, free markets have benefited from the experience of traders to spot the moment. The good ones know when markets are over-reacting and can spot the significance of events that change market direction. Traders knew a 2 point move in Treasuries last week was an extraordinary over-reaction, and therefore a buying opportunity.

But now, traders don’t trade. High costs of capital on trading positions and the Volker rules on prop trading have dramatically reduced the ability of traders to go with their gut feel and actually play and turn around opportunistic markets. The Volker rules apply to all US banking organisations (which effectively means any institution where an employee has as much as been on Disneyland holiday), and any security that may be offered to US residents. Which means most stuff and most significant entities are covered. As Sepp Blatter has discovered… Uncle Sam has a very long arm.

If traders don’t set prices, but can only place “customer orders”, then who leads prices? Not everyone can be an investor-trader! The market’s mind-set is that investors look at prices to determine what they buy. Without prices the effect is functional illiquidity. The result is much more volatility in prices. The immediate reactions of traders are now replaced by the slow consideration of investors, which means prices are far less reliable.

And then add all the other rules, like not being able to play instruments like Credit Derivatives, or restricting hedges to actual assets, or setting punitive capital weights that make little sense, burdening banks with surplus unemployable additional rainy-day capital, or telling the world’s largest investors they are now under regulatory fiat as “globally significant financial institutions” thus making them as cautious and as neutered as the banks have become.

It all adds up to confusion, inefficiency and danger.

I can’t help but wonder if the endgame for the market-regulatory complex is simply to remove systemic risk completely by effectively ending trading and market volatility by making it impossible. If you have no trading, you have no price moves, thus no market shocks or crashed. Tick box. Job done.

If we ever get to that stage, I wonder what Citibank will do with the 24,000 compliance officers I’ve been told it employs at an annual salary bill of over $1.2 billion?