Ever since the so-called “flash crash” on May 6, policymakers have fretted about the state of equity markets. So have investors.
But is it possible that this focus on equity markets is missing a trick? Could the flash crash reveal a problem that goes beyond high- frequency traders?
For Paul Tudor Jones, the hedge fund manager, the answer is yes. This week, he delivered a passionate speech to a CME conference in Florida, which argued that the crucial problem bedeviling all markets these days is a lack of price limits, in effect rules that stop trading when prices have moved too far. He implored regulators to impose these limits, not just for equities and futures (where some exchanges, such as the CME, already impose limits), but for all securities traded on exchanges, including options and derivatives.
“I cannot tell you how many thousands of times I have traded on information that 24 hours later proved to be at least partially inaccurate or irrelevant,” he told the CME conference, adding that “relatively severe price limits” would force “all participants to take a more deliberate approach to external shocks that can only be accurately assessed with more time to gather information”.
It is a bold – if not contrarian – thing for a hedge fund veteran to say, particularly one who has earned billions by playing the (free-ish) markets. As Tudor Jones himself observed, most financial players consider price limits to be anathema to modern free markets.
But, Tudor Jones first cut his teeth trading cotton on exchanges, where limits were in force. And that colors his views. After all, as he told the CME event, in recent decades markets have undergone radical changes: a world that used to be dominated by long-term investors and physical traders has been over-run by highly-leveraged “financial arbitrageurs”. These have lobbied for the abolition of price limits, since a world of 24-hour trading without curbs allows them to make more money on a thin capital base.
At the same time, a plethora of different options and futures markets have emerged, operating under separate regulatory regimes. Taken together, this has created a destabilizing cocktail, at times sparking panics. One example was the equity crash of 1987. A second was the recent flash crash. However, a third example was a price squeeze in the cotton markets back in March 2008, when the price of cotton options (where circuit breakers don’t exist) diverged wildly from cotton futures (where limits are in place). That caused such crazy dislocation that numerous cotton merchants collapsed.
That leaves Tudor Jones calling for three things: firstly, regulators must impose daily limits across all listed securities; secondly, they should review existing limits (say, those on the CME) and probably tighten them. “All stock index futures and options should have an 8 per cent daily limit both up and down, consisting of a 5 per cent move with a one-hour timeout, and a further 3 per cent limit before that price move is exhausted for the day,” he suggests. And thirdly, they must create more consistency between the regimes governing futures, options and so on.
The third of these ideas, the need for harmonization between regulatory regimes is self-evidently a good idea. The point that got the CME conference buzzing, however, is the call for limits. Some pointed out that defining how circuit breakers might work in derivatives markets is no easy thing and it would be even harder to impose them across the world in any uniform scale. Given that, some powerful voices argue, it might be better to not use limits at all.
Those naysayers make a fair point; having a regime of uneven limits can create even more distortion than no limits. Nevertheless, I have a lot of sympathy with Tudor Jones’ basic premise. After all, in the past few years, computer activity and information flows have speeded up dramatically. However, the quality of information has not always evolved nor has the propensity for humans to panic less. Giving traders more time to think seems a crucial step to building more sustainable markets which enjoy stronger public support.
But whether regulators will take that point of view remains uncertain. In theory, the Commodity Futures Trading Commission and the Securities & Exchange Commission are considering whether to impose more price limits on exchanges. In practice, there is pressure from Wall Street for less state “meddling”. Either way, Tudor Jones’ comments should not be ignored because in many ways they are entirely sensible. He deserves praise for putting them on the table.