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Market Volatility’s Dirty Little Secret

It’s common investment lore that some asset classes aren’t correlated. Ask a traditional investor if they believe that the equities market correlates to the cryptocurrency market—or vice versa—and I bet you’ll get a “no.” But while the risk profile of these investors may be quite different, the connection between the markets they trade in is not as separate as they might think.

The February downturn showed the cryptocurrency market moving in sync with the Dow. As it dropped, so did crypto shares.

But how? Why? The answer may have something to do with automated trading strategies with correlations executed by machines.

And when these algorithms feed off of each other, increasing the severity of market sell-offs, humans are simply left to stand back and watch. On the most volatile trading days, machines account for up to 90% of trading volume in the equity market.

Yet algorithmic trading remains almost entirely unregulated, and history shows that when markets fall victim to a sell-off driven by their behavior, very little has been done to prevent it from happening again.

August 2007: Quant Quake
Just prior to the start of the global recession, the original Quant Quake shook Wall Street. Quant Quake saw some of the top quant funds in the US, including those belonging to AQR and Goldman Sachs, lose billions of dollars in a matter of weeks.

Because many of the funds at the time were highly correlated, as one firm began selling its equity positions, others did, too, creating a seemingly unstoppable domino effect.

At the time, few understood what caused these algorithms to falter. However, looking back, it’s clear that some of the inherent risks that caused billions in losses were overlooked.

While the global recession and mortgage market meltdown weren’t “expected,” the idea that drastic downturns in other parts of the market — such as the mortgage or credit markets — would have no impact on the stock market and the performance of quants in hindsight look pretty naïve. And with the success of quant strategies, one should have, or at least could have, expected a wide array of copycat managers would come along trying to cash in.

Did fund managers find ways to better understand their algorithms after Quant Quake? Not really. Only three years later, the Flash Crash of 2010 saw trillions of dollars lost from the US equity markets, only to be—mostly recovered—36 minutes later.

It’s clear to me that not only have we not solved the problems that created the conditions for Quant Quake, but that the financial markets are more vulnerable than ever to another fast, unexpected, quant-driven fluctuation. Here’s why.

The rise of automated trading in hedge funds
Since 2007, the use of automated trading strategies has only increased with more than 75% of the US stock market now traded via algorithms. Quantitative strategies have become seen as the active manager’s way of generating higher returns to outperform the growing amount of capital moving into passive investing strategies. This has been seen in the growth of the number of quant funds over the years (from ~10% of the market in 2007 to ~17% in June 2017), as even more fundamental hedge funds are turning to quants or platforms that enable non-technical PMs to run their strategies or ideas through algorithms.

I think the likelihood of another sudden market crash led by automated trading is almost inevitable. As these markets become even more interconnected, and more and more traders and funds are using automated trading strategies, the effects of such a crash won’t be contained just within a small community of hedge fund managers as it was during the Quant Quake. Instead, it will be felt by all investors and funds, and throughout the broader market.

Wider adoption, wider risk
Unlike at the time of Quant Quake, automated trading is no longer just happening within the hedge fund community. In March 2017, Blackrock announced a move to consolidate many of its actively managed mutual funds and rely more on stock picking algorithms, triggering other traditional asset managers to follow suit. This has created a more populous network that relies on quantitative strategies for returns.

Copycats continue, bringing amateurs along 
If Quant Quake revealed dangerous similarities in algorithmic trading strategies among hedge funds, surely this risk has been identified and corrected? To the contrary, there are more copy cats today than there were in 2007. Even scarier, there are more investors that are not quantitatively savvy using platforms and solutions that allow them to enact quantitative strategies as if they were. This also means that there are more investors whose primary focus, or at least significant focus, may be other asset classes, inherently linking quantitative investing to the rest of the financial market.

Regulators come up empty
It took the SEC four months to issue its report on the cause of the Flash Crash in 2010, and it is still generally unknown which fund was the initial trigger for Quant Quake. This issue of the ‘black box’ for quant algorithms remains accepted. But when the next downturn occurs and investors want to understand what went wrong, will we still be okay with not knowing what is driving the decisions of our algorithms?

Regulators have made some attempts to protect against large-scale market fluctuations exaggerated by these algorithms. However, initiatives such as circuit breakers are just superficial solutions. We saw this two years ago when markets went into free fall and circuit breakers were tripped more than 1,300 times and didn’t help share prices of major companies from dropping tens of percentage points in just minutes.

While regulation and more market oversight could help to lessen the risk of a bigger, more widespread Quant Quake, the key issue is transparency. As markets become more complex and interconnected, we need to make sure to understand how they are connected and how actions in one market may or may not impact another.

Amplified equity market risks
While easier said than done, some of the features that have defined the equity market since the Great Recession have only amplified flash crash risks. For most of the last decade, share buybacks have been the main source of capital inflow into the US equity market. On top of that, the quiet IPO market alongside an active M&A market have also led to a decrease in the number of publicly traded companies. The combination of these trends means that there are fewer shares outstanding in the market, which in turn means that even smaller buy and sell orders can lead to exaggerated swings.

To me, this market set up sounds eerily familiar. I don’t think we are far off from another Quant Quake if a significant downturn in the market occurs. So why haven’t we learned? Are events like the Quant Quake now just inevitable? Or are we collectively choosing to not take the necessary steps to mitigate the risks?

The obvious, but uncool, answer: regulation
As someone whose first real awakening to economics and finance was the collapse of Lehman Brothers, there are takeaways from the causes of the Great Recession that can, and should, be useful in mitigating the potential impact of another Quant Quake.

Much of Wall Street lives under the assumption that less is more in terms of oversight. Ten years ago, the industry’s attitude was that it didn’t matter if anyone understood the quality of the mortgages packaged into CDOs. Now, it’s as if it no one cares that few understand how algorithms make trading decisions. As our markets and the assets in it become more complex and interconnected, there are fewer and fewer people involved, even those in the weeds making trades on a daily basis, that really understand.

An analogy from structural engineering world comes to mind. If a large crowd of people on a stadium balcony begins to jump in synch, no matter how strong the balcony is, at some point it will begin to bend and recoil. When this up and down motion inevitably becomes too extreme for the material with which the balcony was made to handle, it may collapse and fail.

The past decade’s market volatility is a similarly exaggerated movement. With the growing number of funds crowding into quantitative strategies, without the right oversight, it’s not too far off to believe that sooner or later, the structure that is the US equity market may too see swings that are too extreme, bringing it to the point of collapse.

This isn’t destiny. But action is needed to mitigate the risks to decrease the likelihood of such a downturn and support the market in the face of future Quant Quakes.

Quant, like rocket scientist before it, was largely a derogatory put-down for the brainy newcomers

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