Markets Work

Linda Rafield, Senior Analyst, Platts

The effectiveness of markets is questioned with every spectacular rise and fall, but those fluctuations are markets at work. Markets work by a few simple rules. Markets have risk, but they are also effective tools to manage risk intelligently.

WHEN THE MIGHTY CRASH AND BURN—think Amaranth, or Enron, or California's something-for-everyone "market" experiment—politicians and experts of every stripe rush to declaim about what could have prevented the disaster, usually prescribing more regulation and government intervention to limit market dynamics. Rarely does someone mention that the mighty who fell were not victims. They were players who forgot markets work.

Periods of excessive volatility that are all too often characterized by aberrant and anomalous price behavior will always come full circle, bringing markets to an oh-so-fleeting equilibrium, but one that ultimately reflects underlying fundamentals. Those who fail to remember that markets work pay the penalty.

Markets Are Cyclical

Technicians develop financial models and propound that markets are efficient and dictated by well-defined rules that allow traders to cash in on recognized patterns of price behavior that are predicated on historical precedent. Some theorists believe markets are irrational, inefficient, and basically just a random walk down Wall Street.

From 1974 through 1981, commodity markets were the only game in town. The catalyst was the demise of the gold standard and the 1973 oil shock that sent inflation and, consequently, interest rates in the U.S. soaring to historic highs. Concurrently, the death of the post-World War II Bretton Woods system, which had pegged major currencies to the dollar, allowed for the free float of foreign exchange and ignited a run in the U.S. dollar that ended in 1986, under the 1985 Plaza Accord, whereby coordinated central bank interventions drove the value of the greenback to levels that were more economically palatable to America and its major trading partners.

The greenback languished for nine years before former Secretary of the Treasury Robert Rubin made America's mantra "a strong dollar policy is in the interest of the United States" and sent the currency surging anew. This particular bull run in the greenback would last just six short years, coinciding with the changing of the guard in Washington, D.C.

The vicissitudes of commodity and foreign exchange markets, while notorious for their rough and tumble nature, were tame in comparison with the 17-year bull run in equities that began in 1983 and ended with a rather loud thud in 2000. Maybe the bubble was in dire need of a bursting. Maybe the bull had just run its course.

Nonetheless, these two bull cycles—in the U.S. dollar and the equity markets—left commodity traders sitting on the sidelines for 20 seemingly endless years, pained, in some cases impoverished, but patiently awaiting their turn. Such is the cyclical nature of markets. And their turn came in 2002.

Markets Have Commonality

Markets are cyclical, by nature entail risk, are often subjected to government intervention—with notably inefficient results—and there are always winners and losers since, in essence, markets are a zero-sum game.

For every buyer there is a seller or no trade can occur, but where each participant takes a profit or a loss dictates who will win and who will lose. The history of markets, be it equity, foreign exchange or commodities, is strewn with wreckage.

From Drexel Burnham Lambert to Metalgesellschaft, Barings Bank, the Bank of England, Long-Term Capital Management—when markets were stopped from functioning by the largest government bail-out in the history of Wall Street—Enron and the recent demise of two hedge funds (MotherRock and Amaranth), the battlefield is littered with an excess of ego and risk mismanagement.

Deregulation of markets in the U.S. has led to brief periods of lawlessness, where everyone seemed to win, and the fallout from that delusion has included overly prescriptive government policies. But dysfunctional regulatory regimes result in misallocated investment and hamper the ability of American markets to be globally competitive. Lawlessness may have been replaced by government oversight, and trading by the seat of one's pants augmented by sophisticated tools of risk management, but only intelligent risk management makes for efficient markets.

All too often, when the largest market players face their failures with consequences well beyond themselves, the U.S. government has become the ultimate arbiter, the lender of last resort, and the price fixer.

Gasoline rationing in the wake of the 1973 oil shock was an outstanding example of an egregious and ineffective response by the U.S. government to market developments. Soaring petroleum product prices, unchecked by government intervention, would ultimately—and quickly—have found the U.S. consumers' inflection point, causing demand destruction, bringing prices to a level that was considerably more acceptable to the end user, and encouraging new supply. Instead, U.S. consumers were condemned to months of rationing according to the numerical sequences of their license plates in an attempt to control demand and contain the seemingly exponential rise in gasoline prices. This can easily be labeled an episode of risk mismanagement.

In 1998, the U.S. government under the stewardship of Rubin—in one of the finest examples of how to trade a market without really trying, or how to behave like a hedge fund—engineered a massive coordination of central bank intervention in foreign exchange markets at 8:05 a.m. EDT (1205 GMT), when the book is normally passed from one global trading center to the next (in this case to New York from London). The intervention caught traders completely unaware and sent the U.S. dollar soaring to levels it would not see again for many years. This is one of the risks of trading in a $2 trillion-a-day market.

Sometimes governments become the entity being intervened upon. In 1992, legendary trader George Soros placed a £10 billion bet against the Bank of England that would force the central bank out of the European Monetary System and devaluation of the British pound. Soros' play was a commentary in itself on the health of the British economy and the viability of rigid foreign exchange regimes. Soros' take was $1.1 billion, calling into question how much of his personal fortune and that of his Quantum Fund were at risk at the time.

One could compare Soros' trade to the one that was recently placed by Amaranth, a hedge fund whose fortunes were vastly diminished by a play on winter natural gas spreads. As with Soros, there appears to have been an inordinate ratio of working capital to the size of the trade, and neither the Quantum Fund nor Amaranth appeared to use exotic derivatives.

Unlike Soros, the gaming table was not so kind to Amaranth. Amaranth lost about $6 billion and secured an unenviable place in the hedge fund hall of fame.

Both hedge funds engendered the ire of governments and cast a pall on speculators. But risk-takers are always envied for the sums of money that are won and lost, and then threatened with regulation as a means of controlling that which is not understood—trading, and in particular, exotic derivatives.

Markets Are Innovative

Derivatives once solely encompassed the futures markets. Then came options, and options on futures contracts, which begat swaps and swaptions, and swaps on volatility options, and an ever-burgeoning array of instruments that can reduce or increase risk, depending upon one's level of financial sophistication. One has only to look at the menu of instruments that can be traded on the New York Mercantile Exchange, ICE Futures, and global exchanges from Chicago to Mumbai and Dubai, let alone the over-the-counter (OTC) markets where financial whiz kids will structure a deal that surpasses the imagination of a Hollywood scriptwriter, which is why medical dramas are ratings winners and Wall Street never makes Nielsen's top 20 most-watched TV shows.

"The explosive growth of non-traditional sources of liquidity—especially derivatives—seriously complicates the measurement problem," Stephen Roach, chief economist at Morgan Stanley, said in a note to clients October 9.

Bank for International Settlements data "put the notional value of global over-the-counter derivatives markets at U.S. $285 trillion in December 2005—up more than 40% from volumes just two years earlier and more than six times the nominal level of world GDP."

The explosive growth of OTC derivative markets, the implosion of the power trading sector with Enron's bankruptcy, and recent criminal cases against energy market participants have led to numerous attempts by Congress to impose a more burdensome regulatory regime, rolling back hard-won benefits obtained from the Commodity Futures Modernization Act 2000 (CFMA). Under the CFMA, OTC derivative markets remained exempt from U.S. government oversight and some of the more restrictive regulations on futures exchanges were removed to ensure global competitiveness.

"Already the largest futures exchange in the world is no longer in the American heartland; it is now in Europe," Alan Greenspan, then-chairman of the Federal Reserve Bank, said in a speech before the U.S. Senate in February 2000. "To be sure, no U.S. exchange has yet to lose a major contract to a foreign competitor. But it would be a serious mistake for us to wait for such unmistakable evidence of a loss of international competitiveness before acting."

Greenspan's comments were prescient. The New York Mercantile Exchange currently stands a chance of losing its benchmark light, sweet crude contract to ICE Futures, since foreign boards of trade are not regulated by the Commodities Futures Trading Commission (CFTC). The commission is deciding its stance at this writing.

Even without CFTC action, U.S. futures markets remain a bastion of price discovery, transparency and risk management, particularly compared with unregulated foreign boards of trade. If a regulatory regime is not, or cannot be, uniformly applied to all designated contract markets, investors are international and have already shown they will move away from the heavier regulation.

The New York Mercantile Exchange currently boasts a guaranty fund of $150 million and has a AA+ long-term counterparty credit rating from Standard and Poor's. (Standard and Poor's, like Platts, is a division of the McGraw-Hill Companies.) Original margin deposits are augmented by variation margin for traders holding open positions. Open positions are marked to market at the end of every trading session and, using a system known as Standard Portfolio Analysis of Risk, the exchange stress-tests each portfolio, calculating a worst-case scenario. Each clearing member is required to contribute 10% of its modified capital for each division membership; the minimum deposit is $100,000 with a maximum contribution of $2 million per division. Customer funds are segregated from the Futures Commission Merchant's capital to protect traders, large or small, from a potential default by a clearing house.

As a self-regulated organization, any futures exchange knows the benefits of protecting its customers. Additional oversight by regulators simply sends business packing overseas.

Markets are governed by rather simple rules of risk management:

• No one trader or house is bigger than the market itself; to think so is sheer folly and almost always results in a for-sale sign being posted.
• Never average a bad position; to do so only aggravates a mistake.
• Always mark-to-market a position; where one initiates a position is only relevant to the settlement price and then the position is the settlement itself.
• Never risk all of one's working capital because that is the surest path to the unemployment line.
• Ego trading is the fastest road to ruin.

Those who do not adhere to the very basics of risk management generally do not have longevity in a business that can be unforgiving. The winners and losers, regardless of the circumstances, are proof that markets do indeed work.