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We’re out Wednesday due to Memorial Day on Monday. For those new to the Market Structure Map, holidays delay clearing processes, so data at the Nasdaq and NYSEnet was a day later this week.
One word before we talk arbitrage: you might’ve read last week that major Prime brokers Goldman Sachs, Morgan Stanley and UBS will share access to each other’s internal crosses, or “dark pools,” for algorithmic trading in US equities. Why would competing Primes do that? It’s always about money. By joining forces, they might get more big institutional dollars now flowing to alternative systems, or compete better for large orders. Plus, institutions are currently skipping both brokers and exchanges en masse and meeting in the middle at electronic platforms.
What’s it mean to you, IR folks? Well, don’t be surprised to see an uptick in equity research in the near term as these sellside firms push out new solutions to their biggest institutional clients. Research offers reasons for institutional sales teams to call on accounts and get fund managers and traders to try things out (this is not cynicism, it’s realism).
Now, arbitrage. We saw lots last week as traders gamed gaps between reset stock and index futures and expiring ETF volatility measures. You hear the term all the time. What is arbitrage and why should you care, IR folks and execs? Care because the pursuit of short-term price disparities is obsessive in the capital markets today and regularly drives stock prices. If you’re unaware of these effects, you’ll draw wrong conclusions about investors’ reactions to things you say and do. You might think, watching modern political processes, that accuracy is an anachronism about which you need no longer concern yourself. Do not apply this flawed reasoning to your IR programs (a little humor there).
Broadly speaking, arbitrage is buying and selling financial instruments in different markets simultaneously to capitalize on spreads created by inefficiencies. Regulation National Market System was crafted to combat these practices in equities by requiring equal pricing access at all market centers. Instead of preventing the practice, Reg NMS encouraged trading securities in different currencies, or trading a stock and its associated futures contracts on other markets – like buying a stock at one market and its put or call at another and waiting for values to diverge. With technology, these divergences occur very rapidly today and have great appeal to investors: they offer both instant gratification and the ability to blame something or somebody else for errors (“It’s the data, man, not my decision-making”).
There are two basic forms: “risk-free” arbitrage, where buying and selling are equally offsetting and profits are a function of speed and efficiency; and “risk arbitrage,” such as bets on mergers and acquisitions (for instance, playing the real underlying equity value against options priced by supposed deal premiums) or trading two correlated equities long and short when they briefly diverge.
Sometimes it’s more about balance sheets than stocks. Say you’re carrying debt and the note holders have put various safeguards in place in the form of hedges. Traders with sophisticated software could trade aggressively to trigger changes to those hedges by buying up stock or industry ETF futures and shorting your stock or a group of related stocks.
Who does these things? Your usual New Jersey and Florida suspects, of course (no offense…that’s just IR humor). And for every opportunity, there’s a broker-dealer or trading platform that’s focused on making money exploiting it. Exacerbating these effects is the fact that now major institutions under pressure to produce returns are allocating percentages of managed monies to sellside firms such as Goldman Sachs and Deutsche Bank for short-term trading and classing them as alternative asset strategies. We think that the sovereign wealth funds blossoming in resource-rich developing regions will be feeding these machines too.
Relax, there’s good news too, IR folks! Your ability to provide correct answers on a more nuanced basis increases the value and sophistication of the IR function. And where knowing your holders is difficult today, seeing what’s behind your volume and price isn’t hard once you understand market structure. Plus, there are tactical responses that smart IR practitioners can take during times of high speculation. And then again sometimes you just have to accept algorithmic reality.
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