Will New Regulations "Stabilise" the Financial Markets?

Regular readers of the Trading Gurus blog will be aware that we have been pondering the possible effects of additional regulation on markets on both sides of the Atlantic for some considerable time now. In this guest post Alex Krishtop of Edgesense Solutions speculates about what the future holds for the world's financial markets. In our view Alex's crystal ball is much clearer than those of the vast majority of market commentators.

For more than a year regulators on the both sides of Atlantic have been working hard applying new restrictions to many different markets. The swaps market was possibly the first to undergo major changes. Then followed other derivatives and most OTC markets in general. Attacks on HFT are another substantial segment of modern regulatory activity. The spot FX market was also not left untouched: severe restrictions on banks’ prop activity have already caused a serious restructuring of the whole business and generated a great number of job seekers, but with the most recent proposals by the Financial Stability Board it’s now not unlikely that a centralized clearing facility will be established for this largest OTC market (so far).

What are the consequences of all this unprecedented activity and who are its real beneficiaries?

The average Joe might think that all these measures are indeed intended to reduce “market manipulation” and therefore to “protect” something, his pension savings for example. Probably this is the official decoration for all these processes. We should note here that the chances are, though, that the average Joe won’t ever understand what this campaign is all about. However he doesn’t need to.

Looking at these processes more critically one could easily note that all of them imply greater centralization of all markets and an increasing role for the exchanges and central clearing houses (and similar centralised structures). Therefore the regulatory process probably serves the interests of the exchanges and large brokers. As an immediate effect it causes increased expenses (considering just the new reporting requirements — not every institution would be able to afford it!), and as a consequence — increased transactional costs, at least for most trading venues. As the result, only the really big players in this market will be able to afford to conform to the new rules of the game. Therefore their importance will increase further while minor market participants are likely to further lose their share.

Now what is there in this analysis that could be useful for market speculators? Presently the market is right in the middle of the process of restructuring, and when this process is over we will see a completely new world. The fact that the market is currently in transition is most likely the very reason for the unprecedentedly low volatility, and understanding this reason helps one to estimate how long it might last. With the increased transactional costs we can expect the “come-back” of trading in underlying instruments instead of derivatives, with possible a greater focus on commodities. Besides that the new environment may significantly diminish the reward/risk ratio for many (if not most) short-term and ultra-short-term strategies, along with “market neutral” strategies. In other words, everything that used to generate 20% annual profits with virtually zero risk (“a new standard”, as one of my friends said) might well be rendered useless.

However the most likely and most influential outcome of the whole process will be dramatic reduction of liquidity in all markets, but especially in FX, that will lead to increased volatility and in general a result that is diametrically opposed to that declared by the regulators. Then we might expect the volatility-based alpha-generating strategies to celebrate the “great come-back”.

It’s especially interesting that the end of restructuring of markets will most likely coincide with the end of tapering, QE and ZIRP. This may lead to even more interesting market phenomena.

In conclusion, please don’t throw away your old breakout strategies just yet!