The increased volatility and velocity of markets cannot simply be attributed to electronic matching and short-term traders. At roughly the same time that commodity markets were making the transition to electronic trading, the phenomenon of index funds was occurring.
While the Goldman Sachs Commodity Index had been available as an investable index for some time, it along with other index funds experienced huge growth throughout the decade. Commodity imbalances and a rapidly weakening dollar led to concerns over an uptick in inflation and long exposure to a basket of commodities was promoted as a hedge against the onset of inflation.
These index funds represented a new type of trader in commodity markets. The funds would enter at a predetermined time and roll their long positions month to month based on specifications of the index. These positions were not subject to the same price pressures as your typical hedgers and speculators as they represented a small allocation of a much larger portfolio. They have changed the nature of some fundamental spread relationships and offered headaches and opportunities to the traditional market participant. The amount of money dedicated to long only commodity indexes was estimated to be $15 billion in 2003, by 2008 estimates of the size of that space grew to between $200 and 300 billion.
The political pressures placed on the market based on those who would place the blame on speculators have led to some pretty significant and outright wacky recommendations.
“They are interviewing people in the government every day. It creates this nature where people reduce their size and their liquidity goes down and everybody loses,” Linn says.
There also is the problem of fat fingered mistakes and trading on
“Sometimes they are errors and sometimes they are more tactical errors in terms of the person placing too big of an order without a limit and if you hit a vacuum or the wrong part of the day, it could be brutal,” Haar says.
It got brutal in March corn on Dec. 30. Linn noticed what appeared to be a fat fingered error — supposedly a clerk placing 5,000 lot instead of 500 — shortly after the open (see “Oops”). “I had orders in to buy and was executed,” Linn says. “If I was long the market and went through my risk point, what would I do? Most of the time I wouldn’t exit out. I would look at the trade and say ‘that is stupid.’”
However, that is a tough call to make when it is your money flying away. There undoubtedly were traders who were stopped out and took significant losses only because perhaps an inexperienced clerk was working a trading desk over the holidays.
Linn says, “The environment created is one of a very spastic nature where we move in a direction very quickly and then don’t follow through the next day. You tend to blow through your risk parameters very easily.”
There are a number of factors that have made life more difficult for systematic traders, including extreme volatility, political and regulatory pressure and index fund activity. Electronic matching has made the industry more efficient and has cut costs. These efficiencies have led to new types of trading strategies that has also changed the nature of the game. The anonymity provided by electronic venues has led to less certainty. While some of the changes have benefited managers, others have made for a more risky environment.
There were always traders looking to run stops, but they also were dedicated to providing deep two-sided markets. Managers and hedgers may have had to give up an edge, but they knew there was someone willing to stand up and make a market.
The purpose of futures markets is risk transference and price discovery. To discover prices, traders need to show them and to transfer risk one must see a price.
“All markets evolve. This will straighten out when people understand what is going on and have a good feel, or they will simply lose their money and go away because markets that are spastic like this are almost meant to take the money away from the uninformed who think they can be smart enough to trade this type of market,” Linn says.
Locals provided an important service and while there is no going back, progress always comes with a cost.
“Sometimes you have to be careful,” Linn says. “The markets screamed to kill the goose of the middlemen, thinking that he was making a fortune and provided no function. In fact, now they are seeing that he indeed did provide a stability function and execution function that was extremely important.”