The Blow-Up

There’s a lot to say about Bryant Urstadt’s article about quant traders in this past fall’s Technology Review (free reg required), called “The Blow-up.” Combined with Amir Khandani and Andrew Lo’s “What Happened to the Quants in August 2007” (.pdf link), it gives a fuller picture of how quantitative finance is altering markets.

Clumping quantitative derivatives traders together is getting to be a little too gross a distinction, but there are, it seems, a small number of strategies being pursued by these kinds of traders. Two of the most important are: 1) pairs trading and 2) long-short equity trading. Pairs trading is where an historical relationship between two securities are found, tested, and analyzed; and then when the pairs get out of this relationship for no good reason, trades are executed expecting that this relationship reasserts itself. This differs in spirit, but not entirely in practice, from arbitrage trading, which is trading on the differences between two kinds of products which are ‘supposed’ to be identical (a company’s stock and its bonds, for example, or a company’s stock in two trading environments).

Long/short equity trading is when a market-neutral position is taken, whereby long positions are made up of ‘losers’ (under-performing stocks), while short positions are made up of ‘winners’ (over-performing stocks). This strategy is based on the idea that outliers will eventually revert to the mean – effectively betting on consistent market overreaction. Given the behavioral finance work on how people tend to, you know, overreact to news, this makes sense. And because your position is effectively market-neutral – long positions offset short positions – it is possible (for broker/dealers) to highly leverage these positions.

These are two main strategies, and for the most part, they work. So, what happened in August? Here’s my reading of the two articles: First CDOs – the bundled up derivatives from housing loans that are spoken about when we talk about the ‘sub-prime lending crisis’, went into the sink. Second, an outlying series of days in the week of August 6 caused a dramatic drop in the long-short strategy.

The effects of these two events (possibly, though it’s not clear if they were linked) was the following: a bunch of funds began selling equities to liquidate positions in order to meet margin calls for their CDO investments, which pushed pairs trading into abnormal positions. This caused more hardship, and all sorts of things happened – funds sold blue-chips to raise margin cash; and bought back short positions causing price relationships to swing further out of historical norms. Khandani and Lo speculate that one or more of the long-short funds liquidated its position, and that it turned out that many other funds were also engaged in these kinds of trades, so that when one or two got out, everyone else got hammered.

What makes this interesting? A couple of things. First, as markets are brought into tension with one another via pairs trading, they effectively create a new product, with new features and sometimes not-well-understood properties. A Collateralized Debt Obligation (CDO) can package together such disparate cash flows as sub-prime loans and airplane leases; by virtue of the CDO itself, these otherwise distinct streams are linked together. Second, as traders and funds are brought into tension with one another via sharing similar trading strategies, it creates collective action events that simply do not resemble atomized traders. It’s not surprising that the expression of these problems is always liquidity – IMHO that’s a fancy finance way of saying that people act in concert, when they are ‘supposed’ to act according to their own preferences.

Some other interesting things from the Blow-up:
– it’s estimated that 38% of all equities are traded automatically, and that this percentage may rise to over 50% in the next three years;
– computers for some high-frequency traders execute hundreds of thousands of trades every day.

There is a giant blind spot here, rooted in financial theory, enabled by even cautious policy-makers and economists, and executed by very smart people. Sometimes at home when we watch commercials, my partner and I play a game called ‘good for them, or good for us’ – to see if a product or policy or feature is good for the company or good for consumers. I would guess that the number of people who would argue that derivatives trading today is ‘good for us’ is very small.

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