Recent Stock Market Volatility

We received in the past couple of days various inquiries from worried investors about recent "abnormal" stock market volatility. Although Optimum Management Sarl is not per se a long/short equity boutique but rather a global macro/currency investment specialist, I will try to shed some light into the jungle.

Ever since in 2009 the G20 mandated the Basel Committe to ensure that the Great Financial Crisis of 2008 won´t occur again, equity market structure has changed. The Basel Commitee and regulators identified bank´s leverage as one of the main risks for "stable markets". The consequence of this thinking was that banks were required to increase their capital (Tier 1 and Tier 2 Capital) and - at the same time - lower risk. The goal was and is that the banking system should gain considerable resilience to "market shocks". The risk of 2008 shall be significantly reduced. But: this goal has come with a cost - a lower capacity for banks to deploy balance sheet.

The consequences of reduced deployment of balance sheets are:

• bank trading desk´s capacities to warehouse risks have been reduced
• subsequent reduction of daily liquidity (liquidity drainage)
• higher frequency of brutal market movements than in the past

Between end of 2008 and nowadays the value of outstanding securities issued increased while trading desks capacities to warehouse risk have significantly reduced. If equity markets are balanced between supply and demand, the consequences of this liquidity drainage are bearable, but as soon as an imbalance appears, trading desks are no longer able to act as a liquidity buffer. The closure of bank side proprietary desks and consequently a lack of their traditional additional liquidity provision has aggrevated the situation.

In this situation of a lack of liquidity providers, momentum chasing algorithmic trading firms and High Frequency Trading firms act as multipliers of "normal market movements" or in this particular case - equity market corrections.

Market sources are reporting about massive outflows of funds from active funds into passive funds (ETF´s). The Investment Company Institute reported that mutual funds suffered near record breaking otflows of $56.2 billion in the week ended Dec 19th.

Furthermore, it is reported, that the "real catalyst" behind last week´s market plunge was a forced liquidation of active funds. In order to satisfy massive redemptions, mutual funds had to liquidate stocks. Add this to the scarce liquidity conditions (liquidity drainage) and algoritmic trading firms and High Frequency Trading firms chasing momentum - and voila: you have the perfect equity market storm.

All of this while the FED saw the necessity to raise rates "automatically" in a period of well anchored inflation expectations. Maybe, the FED should start to work on their communication skills - and especially the new FED President.