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Traders, market makers hope '18 ends the pain of low volatility - EXCLUSIVE
Thursday, December 21, 2017
Market makers and the trading desks of major banks are hoping volatility can surge back into the markets in the new year, but there is little agreement over whether that will happen.
For much of the year, equity markets have steadily climbed with few dips, suppressing trading activity and volatility. So far in 2017, the Cboe Volatility Index, a measure of implied volatility, has posted the lowest average daily close in a single year since at least 1990, according to the exchange operator’s historical data.
"It's been a pretty painful period for the industry," Justin Schack, a managing director and partner with research and brokerage company Rosenblatt Securities, said in an interview.
Trading companies such as market makers depend on volatility and price swings to profit from increased business as investors adjust their holdings. Lower trading volume has pressured trading companies throughout the year, pitting them against higher market data fees and trading venue connectivity costs.
The drop in volatility, which has fallen consistently since the financial crisis, has cued a wave of consolidation among trading companies that could seep into 2018 if volatility stays below historical averages, several industry experts said.
In 2017, Interactive Brokers Group Inc. sold its legacy options market-making business; Goldman Sachs Group Inc. placed its commodities trading business under review; and a number of market makers and proprietary trading companies such as Virtu Financial Inc., DRW Holdings LLC and Hudson River Trading LLC struck deals to mergewith rivals to gain enough scale to ride out the period.
The "terrible environment" for market makers, as Virtu CEO Douglas Cifu put it in August, has baffled some executives. The year has been rife with typical volatility drivers, including geopolitical, policy and regulatory changes such as President Donald Trump taking office, worsening relations with North Korea and financial companies preparing for sweeping reforms set to hit Europe in January.
"The market has really managed to shrug off political and world events, and really just focus on itself," Interactive Brokers Chief Options Strategist Steve Sosnick said in an interview. "When the market gets into a trend, it takes a lot to break it."
Industry experts have struggled to agree on whether volatility will return in 2018, and if it does, what could prompt it to spike.
Corporate earnings and aggregate indexes like the S&P 500 and the Dow have hit highs in 2017, and the bull market has shown little sign of slowing down in the year's final weeks, said Nasdaq Inc. Advisory Services Senior Director Myles Clouston.
"There's a lot of reason to believe it can continue in the near-to-medium term," he said in an interview.
Vanguard Group Inc. Global Chief Economist Joe Davis said it will take a "material shift" in economic or policy landscapes to spur choppier markets. That could come in the form of central banks taking more hawkish stances, the market pricing in a recession, or a cyclical upturn in the global economy, said Davis, who does expect to see some return of volatility in 2018.
But if the market stays too calm, consolidation among major trading companies and market makers will continue, Rosenblatt's Schack said.
"It just gets to the point where there's only so long you can hold out," he said.
While a more chaotic market could mark a much-needed turning point for traders, Vanguard's Davis, among others, have worried that the steady rise in prices has led retail investors to become complacent with their holdings.
Vanguard, one of the world's largest asset managers, called its 2018 outlook its "most guarded" in a decade. While Davis said the company is not expecting "the sky to fall" in 2018, he added that it would be "naive to think that the extremely strong performance that we've had over the past five years" will continue.
Unlike market makers and trading companies, investors could face damaging repercussions if they fail to properly assess their portfolios or hedge their investments when volatility returns, Interactive Brokers' Sosnick said.
"Markets always work best when there's a healthy balance of fear and greed," he said.
Article amended at 5:38 p.m. ET on Dec. 21, 2017, to clarify Douglas Cifu's role at Virtu Financial Inc.