On Leverage, Volume, and Liquidity Fragmentation!

I watch CNBC and just shake my head when these experts say, “oh there is no volume and that is bad”, or “oh the world will become saner with less leverage”

Pimco’s El-Erian is on record saying that there will be less credit, less leverage and people will become saner. Sorry, but that is not correct. Did you know the ETF’s that are all the rage are the 2x, and 3x ETF’s like this one. If we were really going into a “saner” less leveraged society then these ETF’s would not be popping up, and would not be multiplying. Or how about this broker that gives 400:1 leverage in currencies. Or how about CFD’s, which have a leverage of 20:1.

The reality is that we are going to go into higher leverage, but what will be expected is that we can manage this risk. It is expected that we completely understand what this higher leverage means. And I do think we will be learn to use that amount of leverage.

Next volume is an indicator that people keep trying to follow. And the NYSE EuroNext CEO is on the record saying that there is not enough volume. Sure maybe on YOUR exchange. I say forget volume. I already said this a while back.

Here is the thing about volume. There are other avenues, and right now a problem is liquidity fragmentation.

However, the implementation of MiFID (Markets in Financial Instruments Directive) later in 2007 will explicitly encourage the creation and use of alternative trading venues in direct competition with the existing regulated exchanges.

Significant loss of market share will be experienced by existing stock exchanges. In some cases they may cease to exist as trading venues.

If you are wondering what I am getting at, then let me explain it. The OTC and dark pool market is taking the exchange world by storm. OTC products are products exchanged between two partners without any exchange. Companies like Markit provide infrastructure that allows multiple parties to exchange contracts.

I wrote a reconciliation program that managed the trades for the OTC desk. And some of these products where equity options. I asked the traders what the difference between the market equity option and the OTC option was? The answer was nothing, other than volume and being able to determine your own strike price.

I then asked if the OTC price was better or worse? The answer was, the OTC price is identical to the market price because otherwise there would be an arbitrage. What this means is that volume that might have hit the market is not hitting the market, but hitting the OTC desk. Thus less visible volume.

Then comes the topic of dark pools.

Truly dark liquidity can be collected off-market in dark pools. …. In addition they prefer not to print the trades to any public data feed, or if legally required to do so, will do so with as large a delay as legally possible – all to reduce the market impact of any trade.
…. When comparing pools careful checks should be made as to how liquidity numbers were calculated – some venues count both sides of the trade, or even count liquidity that was posted but not filled.

Dark pools are intended for large trades. Thus either the trades are not on the books, and if they are on the books you find out much much later and hence your graphs are useless.

Liquidity fragmentation is the result of volume being in so many places. Retail, and CNBC does not deal with dark pools, and OTC because these topics are simply not on their radar.

And finally, algo trading is making an impact. Before we used to have people watching the screen saying, “buy 1,000,000”, and now we have programs saying, “buy 100 now”, “buy 100 now”, “buy 100 now”. An algo is patient and can be programmed to do whatever you want. Algo’s are not emotional and do not buy or sell in binges.

Add all of this together and we have a truly new market. A market where these “experts” I think are simply not talking about. I even wonder if it is conspiracy to keep retail traders in the dark. For example I know the EuroNext CEO has dark pools, and why is he not talking about them?

I wish CNBC, and other avenues would talk more about this, than having “experts” rant on things that in my opinion is like complaining about buggy whips.