Email written by Frank Dunn, 8th October 2008. Reproduced with permission and for the record.
Since I was asked this question yesterday by Mike Toogood, CEO of Square Mile estate agents; I have put some effort into collecting the important issues together.
Short Selling per se is the wrong villain; naked short-selling, especially intraday is what needs to stop. The short-selling ban for financial stocks was always slightly clumsy, a temporary expedient to solve an immediate problem. Its effect was similarly temporary: street-savvy traders would always work out ways to circumvent the ban; & they have. I alluded to a few ways in a previous bulletin.
The ban also never was going to address a key part of the problem: intraday trading. Many Hedge Fund managers are former ‘prop traders’ (Proprietary Traders who used to work at investment banks trading ‘the book’ – the bank’s own money - for the bank). As such they learnt not to hold positions overnight unless they were absolutely sure of them.
Instead they dive in & out of the markets, using very short-term trading ‘signals’, nowadays mostly from software, but built around chart patterns; known as Technical Analysis. Having designed a lot of this software personally, I can tell you a great deal about its strengths & weaknesses. The flaws of the software are nevertheless not the biggest threat. It is the timescale at which everyone is now trading; namely building up massive positions during the trading day; and then ‘closing out’ and going home all-square,
Intraday trading like this is normally permitted at very high gearing. This means very little capital is required for moderate positions; but more importantly very large bets can be placed with only modest capital. The effect of this is to exaggerate & exacerbate very short-term trends; in other words it creates volatility and uncertainty by its very nature. This needs to be prevented.
Moreover, the same traders that pursue high volumes of intraday trading also hold what are called naked positions, or raw or uncovered holdings: large one-way bets for longer periods that a particular price movement is on the way. This is completely contrary to the original spirit of hedge fund management; whose name implies that you offset any large positions by counterbalancing investments to reduce risk.
Naked holdings are a similarly destabilising influence and need to be prevented.
Solve the problem at source
The rewards for Hedge Funds in performance fees are enormous. Estimates for the overall size of the business vary widely; but it runs to trillions of dollars.
Yet most of them do not have a clue how to offset risk. I suggest that they either learn or go back to the less rewarding world of conventional long-only fund management.
The way to make them learn is to make them file nightly reports, via their broker as I have suggested previously; justifying the positions they are taking, in terms of counterbalancing holdings in their portfolio. No report; no trades; the reports can be forwarded anonymously to the academic world for verification by postgraduate economists; just like an exam marking scheme. (Bernanke could surely set his up in a jiff?)
Of course in the real world, zero net risk exposure is an impossible ideal. How much exposure should we permit? My suggestion is that they pay for risk exposure by depositing funds pro rate with their regulatory body: 5% net exposure means you deposit 5% of your fund with the regulators.
This means those that are the most destabilising influence have to cough up the most; which seems fair? The funds they deposit can be used to offset instabilities yet further (see next section)
Funding a secondary market for interbank trading; using robot Market Makers
The problem with the interbank market is that it is rife with rumour, as we have so recently seen; and those rumours make everyone vulnerable. What is needed is a secondary market where the borrowers remain anonymous from the general market. For such a thing to operate requires market makers; that is organisations that offer ‘prices’ (interest rates in the case of loans) that they guarantee to meet, rather than the indicative ones of the interbank market.
Market maker software is now sufficiently advanced to outstrip the capabilities of any human: the spreads that are offered need to be adjusted, not just in relation to the order book of the market under question; but with respect to the dynamics of related markets.
I suggest market-making be a non-profit function; run by the regulators & central banks in conjunction with the larger banks. Competing market maker models can be used; to measure their effectiveness of a continuous basis. Funds for the scheme would be obtained from the Hedge Funds who are destabilising the system; as explained in the previous section
There are many other proposals, but these 2 are urgent. Long-term, I would like other investors to ‘do as I do’; and pursue investment schemes that are deliberately designed to contribute to the efficiency of markets; rather than detract from it. This is a big ask; and will take some time. Nevertheless I am happy to report that recent tests of my new smoothing software show we could have traded through the last few weeks; hardly noticing the volatility. Like Noah, I am prepared for the next big storm: will anyone come & join me?
Finally, I should stress that no-one can solve this alone; not even the US cavalry of the Paulson/Bernanke team. It has to be a team effort across the globe; something that we all solve together. So I should stress that my suggestions should be regarded as additional ingredients to be put into the mix; and that they assume the frantic & furious labours of our leaders will get the global co-ordination they need.
Moreover, they are only proposals. Like all ideas, if they are to be any good; they too need the contribution of others to work. The time for heroes & saviours is over; everyone has to do their bit.
Frank Dunn is a professional commentator on Hedge Fund strategies & advisor to numerous financial professionals. Along with many noted academics, he has argued for some time that risk models need updating; to reflect the dynamic nature of sentiment risk; that is the changing behaviour of market participants. He uses a variety of highly mathematical techniques to model this; built upon the theory of Social Networks.