These days there are a lot of comparisons being made with what happened in previous financial crises that unfolded after times of irrational exuberance and reckless monetary policy, but many are failing to grasp how the current situation is hardly comparable to what happened in the past for many reasons.
🚩 1 – Options are in the driving seat, not underlying stocks anymore
No, I am not crazy and I know very well that options (in theory) are a derivative of the underlying contract they are attached to. Because of that (in theory) option prices are supposed to move (mainly) as a consequence of their underlying. However, options contracts are listed on their own. This means that they themselves can be put off balance, even significantly, by dislocations in demand and supply.
Now, this is what the theory says: if a trader comes into the market to purchase a large number of contracts of a derivative, arbitrageurs are supposed to step in to take the opposite position, restoring the equilibrium in line with the underlying asset price.
On the contrary, this is what happens today: if a trader comes into the market to purchase a large quantity of contracts of a derivative, brokers rush to hedge their position in the market because more often than not they are underwriting those options rather than selling off their inventory. This means that the equilibrium in option pricing is being restored by moving the price of the underlying asset and not the opposite. Market manipulators understood this dynamic very well and they weaponized it to move stock prices in particular as they please… up to a certain limit. What’s the limit? The amount of stocks available to hedge the risk. What happens when brokers cannot find enough stocks to hedge or it becomes more expensive for them to do so?
🚩2 – Derivatives are hedged with synthetic positions, including “naked” shorts or longs. No one has any clue about who holds the ultimate risk and what the total size of the risk in the system is.
First of all, sorry to break the spell, but “naked” trading is legal as I discussed in this article a while back: THE CRITICAL LOOPHOLES IN THE LAW THAT MAKE NAKED SHORT-SELLING “LEGAL”. However, the regulator’s “good heart” in allowing loopholes with the intention of facilitating market makers’ lives in illiquid stocks has been abused and taken advantage of (what a surprise). This means that derivatives positions are effectively hedged synthetically with stocks printed out of thin air. When a broker isn’t available to take the other side of a naked short or long, synthetic derivatives hedging is used.
A “synthetic” hedging is a position that is supposed to cover a specific risk of a derivative contract when the exact matching trade is not available in the market. People familiar with structured derivatives know very well what I am talking about. For those not familiar with it, let me help you with an example. Imagine I buy a car and I need to buy a spare tire in case one of the four currently in place breaks. Instead of a car tire, I buy 4 bicycle tires and I place them in the trunk. Why do I do this? Because the sum of four bicycle tires is cheaper than a car tire and, assuming my calculations are correct, in case of need will still help me reach the nearest gas station (hence my risk is “hedged”).
This type of risk hedging is only supposed to exist in the OTC market where brokers accommodate clients with very bespoke contracts and then they handle the risk hedging synthetically, filling the gaps for what cannot be hedged with the bank’s capital (the reason why they charge a chunky fee to enter into these kinds of positions).
What happens if you start applying the same techniques to “vanilla” contracts that are hedged more often than not with other positions “printed out of thin air” without posting the necessary capital (often a mere fraction) because the regulator believes those are “low risk” positions? The mathematical result of this is almost infinite leverage.
At this point, it should not come as a surprise anymore that you hear people screaming for an “emergency rate cut” when major indexes are barely 3-4% down and still over 8% positive YTD. Because of this “infinite leverage” people go quickly underwater.
🚩3 – The 0DTE options aberration
In theory, derivatives are instruments created to transfer risk between counterparts in what is supposed to be a zero-sum game for the whole system. What kind of financial risk is being hedged with daily 0DTE options? None, period. 0DTE options, because of their purely speculative nature not much different from lottery tickets, have been antagonized by most of the regulators across the globe since it is clear even to stones how incredibly destabilizing they are for the whole financial system when they don’t represent anymore a small fraction of the trading volumes.
Think about a casino business. In the long run, the odds are in favor of the casino, right? So how does the casino handle eventual exogenous big wins from its customers that are equivalent to big losses for the operation? With its capital buffer. Do you think things are any different for banks and brokers if you look closely at the nature of these trades?
Imagine the broker being the casino and he sits in the middle of clients who want to bet on small swings in the market with 0DTE options. As we saw above, the flow isn’t perfectly balanced but there is an element to take into consideration here: if the broker hedges a risk that will be off its books in a few hours, the cost will be greater than the spread he gains market-making. So, what do you think all these “wizards” of the trading floor do more often than not? They sit on the positions and only hedge at the very last minute before the market closes. Easy to understand how this type of business is very profitable in a low and decreasing volatility environment, right? Brokers are simply collecting premiums from loser lottery tickets. For gamblers, this will be a “small loss” and they won’t bother much, but for brokers that sell millions of tickets this small loss is a huge gain, isn’t it?
Small problem, differently from a casino where the odds are statistically in its favor, it is not the same for brokers that are effectively picking pennies in front of a steamroller. Why doesn’t the regulator ask them to post more capital to cover this risk? Very simple, because they cannot monitor intraday risk and very often brokers themselves do not know what is the aggregated intraday risk of their balance sheet that is always calculated “ex post”. If you do not believe me, feel free to read “Meeting the challenge of intraday liquidity reporting” or “SG trader dismissals shine spotlight on intraday limit controls” where it is put black on white “Risk experts say many banks rely on daily reports and can’t effectively monitor intraday limits in real-time”.
What is the implied leverage of running an operation with little if no zero capital? Again, it is mathematically close to infinite.
Why are regulators allowing them in particular in the US? Exchanges badly needed a new source of revenue since spot trading effectively shifted from their venues to banks’ dark pools.
🚩4 – Central Banks’ reckless activism
Yes, yes, central banks are not referees anymore but players in the arena since a long time. In particular, since “Greenspan” was elevated to God’s status for saving the markets from their misery plenty of times. However, with central banks’ balance sheets today more than 5 times greater than the GFC, now central banks do command such an amount of assets and leverage that is clearly being used to influence markets’ momentum. In particular to keep volatility “low” and credit spreads compressed, effectively distorting all the risk metrics in the system. Some central banks like Switzerland, Norway, and even Japan are effectively huge hedge funds holding hundreds of billions in stock assets and derivatives in their books in an extreme form of aberration.
All I described above is creating so many “unknown unknowns” that are extremely hard to model and manage. Furthermore, the longer this distortion remains the greater the instability of the whole system. If the default of Credit Suisse which at that time showcased a 20%+ CET1 did not open the eyes of everyone, I am not sure what it is going to take for that to happen. Personally, I do not think that what just happened in the Japanese market is still a loud enough warning to people to figure out how dangerous the whole situation is. And beware, I did not even touch upon the whole risks brewing in the economy in this article so far, if you add all those the situation is a total disaster waiting to happen.
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