Iron Capital Insights

  • Iron Capital Insights
  • January 15, 2016
  • Chuck Osborne

Miss Proprietary Trading Yet?

History will look back at the aftermath of the financial crisis of 2008 as a glaring example of the dangers of reactionary regulation. Don’t get me wrong; regulation – rules, if you will – is absolutely necessary, but like many things in life it needs to be treated with respect. The danger in regulation is the regulator. Who is regulating them? Who is holding them accountable?

To believe that they had no role or responsibility for what happened is to be either incredibly naïve or completely partisan. I’m not defending the behavior of bankers; I am simply stating what should be common sense, that there was plenty of blame to go around. Why is this important?

It is important because the reaction to the financial crisis gave us new regulation, which instead of replacing or fixing things that were really wrong simply attacked phantom villains, such as proprietary trading. People were mad when some Wall Street banks profited from the downturn as they had taken positions that were opposite of many of their clients. But, that is what they are supposed to do – they are broker-dealers, their goal was to give their clients what their clients wanted. If a client wished to buy something, the banks are supposed to either find someone else who wishes to sell (broker) or sell it to them themselves (dealer).

The banks also made markets in the securities that they sponsored. They stepped in when people wanted to sell quickly and when they wished to buy quickly. They made markets work more smoothly. But, as fate would have it, clients often want to sell and buy at exactly the wrong times, so the banks often profited. That supposedly had to be stopped.

This brings us to the worst market start of any calendar year in history – 2016. There are lots of excuses given for this selloff. The first was geopolitical tensions; that has gone out of the headlines and is no longer even being discussed. The second is China and its economic slowdown, but that has been going on for a few years now and even it is starting to grow weary.

The third excuse has been oil. The most honest thing I have heard on the oil story came earlier this week from Morgan Stanley. Their oil analyst was on CNBC and came out and said flat out that the price of oil being set in the market has become completely dislocated from the actual, real world supply and demand for oil. It is all speculation. The oil price is not forecasting some economic doom, it simply reflects the whims of traders, more and more of whom are not even human beings.

All these things may be contributing to a poor start to this year, but none of them equate to the worst start in history.  The truth is that volatility is much higher just because there is no one willing to step in and be on the other side of a trade on any given day. The computers, who are now ruling the daily trading, are either buying or selling. If they are buying, then whatever they are buying is going to be up huge; if they are selling, then whatever they are selling is going to be down huge. Every move is being greatly exaggerated because all the programs are the same and they are all doing the same thing.

Over the last several months this market has really just been stuck in a giant trading range: it goes up, then down, then up…but it is really going nowhere. That is not unusual. What is unusual is the size of the ups and downs. The market is not functioning because no one has stepped in to be the bank. If no one is willing to buy when most are selling or sell when most are buying, then the daily price movements will continue to be exaggerated. This brings me back to my original question. Do you miss proprietary trading yet? I know I do.

This is not the end of the world. The market has always been a voting machine in the short term but a weighing machine in the long term. I do not believe that these exaggerated movements will change that; they just make the ride that much bumpier.

I would love to see real reform to fix the mess we created in an emotional knee-jerk reaction to the financial crisis. Maybe instead of simply reacting to each crisis du jour, we could rewrite the whole rulebook in a way that actually makes sense. Not likely, but we can dream can’t we?

In the meantime, we focus on what is real and what we control. The ride has become rougher but the destination has not changed. This selloff will end and a new rally will begin. Three steps forward and two steps back.  We know what we own and why we own it, and those factors did not change with the change of the calendar. Patience will be rewarded.

Warm Regards,
Chuck Osborne, CFA
Managing Director