Monday, August 6, 2007

The coming doom from hedge funds?















Richard Bookstaber is a quant who has been a financial Zelig. He has been present at many of the major developments of the financial derivatives markets and has had the special quality of being able to reinvent himself with the changes in the markets. I first met him at a Chicago Board of Trade research seminar when he was a finance professor at Brigham Young University. He was a very good researcher and writer who made option pricing theory more accessible to investors. In his new book “A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation”, he makes the inside working of trading firms accessible to the average finance reader.

In his book, Bookstaber presents a rich history of the major financial trading problems of the 1980’s and 1990’s. His perspectives on innovative trading strategies are the main focus of the book. He lived this work and writes with a confidence of someone who knows the markets. Nevertheless, the book's key focus concerns the power of liquidity. Liquidity trumps all other risks in a crisis and is the focal point for potential contagion across markets. In that sense, the title of the book is a misnomer. This not about the demons of derivatives and hedge funds, but the simple issue that when liquidity is not present, the best laid plans in trading will be thrown asunder. This can happen with simple relative value trades across the Treasury market or through complex options structures. Without liquidity during times of stress, Wall Street can be brought to its knees.

Innovations are not bad. They often times serve a specific purpose or hedging need. It is the excess use from an innovation and the unattended consequences when an innovation needs liquidity to work that is the main problem. The combination of high volume with a specific strategy and a sudden loss of liquidity is a toxic cocktail of risk. Herding behavior whatever the cause leads to the potential for liquidity crises and herds will stampede when risks all start to move in the same direction and are concentrated in a specific financial structure. Do derivative products make these problems worse? Anytime there is leverage, risks will increase. Th ability of a trader to sustain loses is rescued when leverage is increased. Leverage can be a demon when it is put in the wrong hands, but it also serves the purpose of proving trading liquidity. Leverage allows those with trading skill to provide capital when it is needed. There are two sides to this argument.

In some of Bookstaber’s Wall Street tales, it is not the innovation which is the root problem but old fashioned leverage which is the issue. Leverage causes time to speed up. Risks are greater and decisions have to be made faster. the margin for error is reduced. Positions which may have long-term gains will have to be sold to meet margin calls. This demand for added funds to meet margin requirements is what drives the market to liquidity crises. The demand of cash is great and the time necessary to find or access cash is limited.

The ultimate problem is whether there are firms willing to provide liquidity in a crisis. In fact, one theme of this book is the lament of the author for firms that can be risk-takers and provide liquidity during times of dislocation. In the “good old days”, the trading partnerships were willing to provide liquidity. They understood the risks and were willing to fill the gap when liquidity was in short supply.

In the current corporate environment, there are those who have the capital but they often do not have the willingness to bear risk during a liquidity crisis. A strong argument that comes out from this work is that firms that can understand fair value during a liquidity crisis are needed. These are firms willing to add capital even to losing trades because they believe that they will be paid for adding liquidity in the long-run. This type of risk taking requires experience, clear understating of markets, and a focused management structure that is willing to subject itself to loses in the short-run in order to see long-term profits. The poster boy for this risk-taking was Salomon brothers when they were a trading leader. It is unlikely we will see that behavior from banks today. Risk-taking during liquidity crises is unlikely to be made by organization men, but only by firms whose sole purpose is to trade. These firms may not exist, or they may only exist in another form, hedge funds.

This book actually argues that some types of hedge funds could be the firms that have the ability to provide liquidity in a crises and serve the purpose of old trading firms. Of course, it takes a special firm to do this work and there are many hedge funds who actually would be contributors to a liquidity crisis. Nevertheless, it is the focused behavior of hedge funds who may be angels not demons. Look at the firm Citadel who has provided liquidity during the recent sub-prime crises and has bought the energy book of Amaranth when it had a liquidity crisis. Of course, it was motivated by profits but it had the vision and structure to be willing to commit funds during a crisis. Citadel bought at a discount but it is willing to hold for a long-term gain if necessary.

While one example does make the argument, hedge funds may be the marginal providers of liquidity in a crisis. The issue is whether they are able to obtain the necessary liquidity from banks and investors when a crisis hits. Liquidity providing requires the ability to obtain capital in a crisis. The current system of risk management such as VAR may not allow for this to happen. Perhaps lock-up term terms by hedge funds is actually a positive for the market as a whole during a crisis. The biggest problem with a liquidity crisis is that if funds are not available in one markets, they will have to be raised in a more liquid market even if there is a not a direct link between these markets. Correlations will collapse to one as money is raised for margin.

The other key argument that is not as fleshed out by the author is the problem of complexity. Greater innovation increases the complexity of the business which means that risk management becomes more difficult. If it is more difficult to see the risks and determine whether you will be compensated for providing liquidity, you will not do it. Complexity will also add to contagion. If you do not understand the extent of risks, you will reduce exposures across the board.

"A Demon" is a well-written and interesting book, but the focus should have been different. The demons we are facing are the same as in years past, liquidity. The potential threat to the markets form innovations may be greater but it is the lack of market players to accept risk which may be the biggest risk we are facing.

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