The departure of several high-profile banks from the metal trading business has been welcomed in some quarters – indeed my own view is that banking is banking and trading is trading, and the two do not necessarily sit that easily together – but there is little doubt that it raises some further issues. Back to the thorny problem of volume and liquidity, and their effect on volatility. Liquidity is the lifeblood of markets, keeping them from being bent out of shape; volume looks a bit like liquidity, but if it’s excessively one-sided, then it is precisely what does bend a market out of shape. In recent years, the most consistent providers of liquidity to metal markets have been the major banks; with their withdrawal, and the ones replacing them being significantly smaller (on the whole) it would be a fair assumption that a gap will be left in the market, where that liquidity used to be. I’ve said before that in my view the hedge fund/trader/private equity groups are the most likely to fill that gap, particularly given the way they have snapped up departing bank traders, but whether or not they will be so consistent in their activities is perhaps open to doubt.
Focussed Volume
Look at it this way; the banks have had enormous pools of capital through which they have had exposure to pretty much every trading market there is. They have also been run – mostly – by banking generalists, who have limited specific knowledge of individual markets. In other words, they have had a lot of money and a general policy of spreading that money across a whole spectrum of markets; that means pretty much constant involvement across the board. But contrast that with a trading house or a hedge fund. There, specialisation rules the field, particularly in a trader, concentrating, say, on metals and energy. Although the funds are there, they are going to be used in a far more targeted way, not so much “we have to have exposure to this market” as “we know this market inside out, it’s our business.”
That different emphasis implies a different style of behaviour. There’s no longer the kind of implicit feeling of – almost – obligation to provide liquidity. Instead, there will be a much more focussed use of volume when it suits. Where that changes things for the market is in the level of volatility. It may not always have seemed like it, but the effect of the banks’ provision of liquidity was a smoothing one, given that it was largely omnipresent. Without it, that smoothing force is gone, leaving the market more open to violent movements, which make for greater instability – or volatility.
Volatility
Now, volatility per se is not a problem; indeed, if there were no volatility in markets, then not many people would be that interested in trading them. It’s the volatility that creates the profit (or of course loss) opportunities. However – and this applies particularly to option traders – without a sufficient pool of liquidity, exploiting those opportunities is problematic. Where we seem to be heading at the moment looks like straight onto the horns of that dilemma; volatility caused because the blanket liquidity is not consistently there. Added to that are the activities of high-frequency algo-traders, whose behaviour when looked at in this way is parasitic. They feed off what one might call legitimate trading, while offering no benefits; their tactics have the effect of siphoning liquidity out of the market before it becomes generally visible. Put those factors together and you get the potentially poisonous cocktail of volatile markets without the liquidity available to trade comfortably in them.
“Warehousing Risk?”
One large bank has chosen this time to differentiate itself from its peers and decide that now is the time to increase its commodity activities; that may prove to be a masterstroke, but the phraseology is a little concerning. They are going to ‘warehouse risk’ for their customers. Well, back in the heady days before the 2007/08 crash, a number of other banks were able to persuade certain insurance companies to ‘warehouse risk’ for them. To those of us watching closely, it looked as if ‘warehousing risk’ really meant ‘dumping on you stuff we really don’t like’ and, if you recall, it broadly didn’t end well. Let’s hope history doesn’t repeat itself.
Unintended Consequences
Overall, some – including me – have been fairly critical of the banks and their influence in commodity markets over recent years, but I think one has to acknowledge that for reasons like those I’ve discussed, their presence will be missed. And, by the way, this same trend is going to become apparent across other markets, as well as metals, as the trading activities of banks are wound down under regulatory pressure. It’s always the same – you get what you think you want and only then do you learn about those pesky unintended consequences.
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