As someone who has spent the better part of 20+ years in front of screens watching intraday financial market price action, the past decade has been a process of increasing change. The way markets have traded has shifted, as the structure mutated from specialist-driven human market making towards big data-driven quants.
The evolution of quant-focused traders probably kicked off with Edward Thorpe’s ingenious discovery of the opportunities presented via statistical arbitrage in warrants. Another huge milestone was the revamping of Renaissance Technologies' famous Medallion hedge fund by Elwyn Berlekamp in 1989-1990. The fund’s returns are legendary and resulted in mind-numbing wealth for its partners, including James Simons’ reported net worth north of $25 billion - not bad for a math professor!
For those who have not, Roger Lowenstein’s book, When Genius Failed, documented the rise and fall of Long Term Capital Management (LTCM), whose demise famously culminated in what some, including your’s truly, consider ground zero for the era of the US government backstopping Wall Street via moral hazard creating bailouts. What had begun as a fairly simple arbitrage-oriented strategy of buying off-the-run US Treasury bonds and shorting on-the-run newer issues with leverage metastasized into all sorts of leveraged bets as assets under management and hubris grew exponentially.
Part of the LTCM story was the mystique that grew around the fund, as they had spread out their trading across the Street. One thing Wall Street is pretty good at, along with walking the line between provable white-collar crimes (only alleged of course), has been reverse-engineering what others are doing in order to make money. As word spread of LTCM’s strategies and positioning, others began to piggyback and mimic.
The result was a sort of sandpile model-type hypercritical system dynamic so that when the avalanche began and the sharks circled to shoot against all the trapped copycats, the US government engineered a ‘kayfabe’ bailout - i.e. one that was supposedly done amongst private banks, but for whom the Fed had backstopped and assisted.
What does any of this have to do with the present? Starting post-GFC when The Dodd-Frank Act served to ‘reform’ Wall Street, the quantification of price discovery went into overdrive. I personally began to notice it in late 2011 and into 2012. For example, a large stock market index component would gap down off a bad earning report, and other large components would gap higher and trade in what I saw as an odd fashion based on no material news. Something like Apple might gap down 4% and Microsoft and Amazon might gap up 2% each - that sort of thing.
Then the following developments emerged:
The explosion of passive investing’s uptake with the flows from related systematic investing via things like target date funds in 401k’s
The explosion of flows from corporate share buybacks- much of which is being done to mask the epic amount of share dilution for senior management enrichment, as chronicled in this recent Epsilon Theory piece.
The explosion in ETF creation.
The explosion in index options trading since the orgy of pandemic-era stimulus found its way into financial markets.
Those known and relatively reliable flows may have created a “fish in a barrel” situation, with the scale of all these flows having grown significantly.
For those running various quantitative-based arbitrage strategies, the more ‘nodes’ upon which to arb the better. It is my theory that this entire quantification of market structure has manifested in a sort of tail-wagging-the-dog situation each day, as a quant game theory circle jerk unfolds on a loop.
The LTCM analogy comes into play with the potential for a sandpile situation to have emerged as copycats have jumped into the game and depressed profit margins from arbitrage. This can lead to more leverage and mission drift, as it did at LTCM. What evidence is there that such a thing could be occurring? At the same time, will the incremental growth rate of the flows peak? Have some already done so?
The insane orgy of short-term index options trading could be a red flag in this regard, in my opinion. What better manifestation of increased leverage could there be to push market prices around upon which to ‘arb’ all of the various nodes available? Do we really need options on S&P 500 e-mini futures contracts? Did we really need the 15th ‘new’ options exchange to be opened?
Seen through the lens of arbitrage nodes, these are not at all about creating market liquidity or bettering price discovery or execution. The beast of growth in nodes must be fed in order to keep the “Ponzi” going, and if my theory is even remotely accurate, then the ramifications may make the recent FTX situation look like the “New Century” of this cycle.
Another great read. Thank you.
Most of the people I have discussed the LTCM fianco with still believe the banking system would have gone belly up had Greenspan not "rescued" LTCM. I argue there was never any proof of that and we should have let LTCM go belly up just like we should have done with GM. Now they have created a dangerous precedent which will never end until the end. Am I wrong ?