Musings on the Microstructure of the Market for Risk

Margin Call (2011)

In closing the previous dispatch I offered that we may be missing a theoretical piece of the puzzle. Here I offer some musings on what sort of structure I think we need to get an even better handle on asset prices.

My understanding of the microstructure of the dealer ecosystem suggests to me that we have three kinds of market players in the market for risk: sell-side, buy-side, and noise traders. US securities broker-dealers on the sell-side make markets by trading at quoted prices. They also provide funding for the trades which consumes balance sheet capacity (the risk-bearing capacity of the sell-side relative to the scale of the buy-side which I have argued is the right pricing kernel in intermediary asset pricing). Noise traders are needed to close the model. More on them later.

Balance sheet capacity is a joint function of the relative ease of funding in the wholesale funding market on the one hand and the market clearing price of risk in the over-the-counter derivatives market on the other. When the price of risk is low (ie when asset valuations are high) more funding can be secured against the same collateral than when the price of risk is high (ie asset valuations are low). This generates a dangerous feedback loop between the market price of risk and the ease of funding.

To be sure, default-remote bonds serve as collateral in the rapidly spinning rehypothecation flywheel because the stability of the flywheel requires the absence of default risk. The proximate cause of the GFC was the fateful introduction of private-label RMBS into the flywheel. And it was the great sucking sound of the wholesale funding market that generated the housing finance boom. Once debt burdens triggered a massive wave of defaults and credit risk reached the flywheel it tottered and shrank, but continued to spin rapidly in its shrunken state on public collateral. But the crunch of the wholesale funding market generated a massive seizure in the machine of global credit creation, sending a massive shockwave that propagated worldwide. Only those with autonomous financial systems insulated by thick regulatory firewalls and those too remote to have been penetrated by global finance managed to come out in one piece.

In the aftermath of the GFC, an intrusive enforcement regime of limits on bank leverage, balance sheet surveillance, risk-assessment, and other regs have reduced the elasticity of dealer balance sheets. The sharply reduced risk-bearing capacity of the system is reflected in breakdown of the iron law of covered interest-rate parity, volatility spikes, and the risk on-risk off behavior of asset prices. Due to the upper bound on the leverage of global banks, the ease of funding has become a function of US monetary policy with the result that the strength of the dollar has emerged as a barometer of the price of balance sheets. Indeed, the strength of the dollar is now priced in the cross-section of US stock returns.

With the dealers pinned down, fluctuations in the market price of risk can be expected to driven by developments on the buy side. Investment strategies of large asset managers are variations on a small number of themes. Big institutional investors like pension funds and insurance companies (‘real money investors’ in the finance jargon) are bound by regulation and governed by similar investment philosophies to maintain asset allocations in certain definite proportions, which requires periodic and tactical rebalancing of their portfolios. When strategists speak of rotation in and out of asset classes, it is these real money investors that they usually have in mind. Also on the buy side are less constrained hedge funds who make up for their smaller size ($3 trillion AUM in the aggregate) by their tactical agility and willingness to make lots of leveraged bets funded by the dealers. Somewhat between the two are leveraged bond portfolios like Pimco who are interested in holding positions with ‘equity like returns with bond like volatility’ (Bill Gross:”Holy Cow Batman, these bonds can outperform stocks!“). That’s your buyside.

Then we have the noise traders. We can think of them as low information small retail investors, or plainly speaking, the small fry whose herd behavior is driven by sentiment. They kick asset prices away from fundamentals by randomly bidding asset prices too far up or down, thereby generating positive risk premia that are then harvested by the big fish. More generally, the game is subtly rigged towards the house by structural advantages of the dealers. In particular, privileged access to order flow information puts dealers is a position of tactical advantage. Apart from trading for the house, traders at dealer firms share order flow information (and therefore the information premium) with their networks on the buy side in exchange for a larger volume of trades with their attendant commissions. Moreover, since exposure to fluctuations in balance sheet capacity comes with a juicy risk premium, dealers and their counterparties in the market for risk enjoy higher risk-adjusted returns than the small fry even without exploiting order flow information. Furthermore, traders on the sell-side are not beyond generating handsome profits by pumping asset prices up and down or otherwise loading the dice. Although the real scandal is what is perfectly legal.


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