Usually, it’s a sandwich, occasionally a salad and since I’ve been in Hong Kong it’s a rice box. However, today we’re not going to be discussing my dietary plans.

Once a quarter I’m able to catch up for a lunch with a group of friends and ex-colleagues from across the financial services industry. It’s a private discussion and topics can range from equity volatility, market trends, monetary policy, trading in an Asian restricted market, an election, Brexit, a new product, a hedge fund launch, who is hiring, changing regulations or just what’s interesting in the market.

Around the table this time I’m fortunate to have a deep bench of market practitioners to speak with. This includes a Global Macro Strategist, a CIO for a Family Office, a Hedge Fund Asset Allocator for a Fund of Funds platform, a Financier turned Start-Up CEO, a Regional Sales Trader, a Crypto Hedge Fund Manager, a Journalist and an Equity Derivatives Strategist. We all follow a similar format to reflect on 2018 and offer our thoughts for 2019.

Here are my reflections for 2018:

I was surprised by how surprised the financial markets have been in 2018 with widely telegraphed activity. With a new Fed Chairman and rising real US interest rates for the first time in nearly a decade, we saw the VIX volatility contract move sharply on two specific occasions by more than 200% over a one-week period. More recently this looks to now moving to a possibly higher trading range.  With the northbound trajectory in US rates and quantitative tightening, why would the VIX volatility contract remain around the 2017 all-time lows?

My key reflection for 2018 was that how significant level of recency bias is so deeply ingrained within financial market participants and it’s something to watch into 2019 carefully.

Here are my thoughts for 2019:

Market structures are changing, creating opportunities and challenges for asset allocators, investors, risk managers and traders alike.

The significance of risk parity investment structures, the growth of passive investments and electronic market makers have generated new challenges to the market. As these investment mandates have grown they have had an effect on price discovery and liquidity.

The investment structures remove a discretionary bias that exists for an active investment manager. The investment processes that they operate under mean when they have new capital they, by legal mandate, have to make an investment, irrespective of the prevailing market condition. This constant bid has created an asymmetrical bias in terms of liquidity and has yet to be tested and proven when market sentiment, flows and direction change to redemptions and a down ticking market.

Electronic market makers offer a mechanism to provide investor liquidity, however, when most of these businesses are structured to reduce risk if they start to lose money we should expect to see lower levels of liquidity if the market moves outside of its daily trading ranges and increasing gap’s in price discovery. Take a long look at the pricing and liquidity behaviour of the S&P500 mini contract during February and more recently in October to better understand this.

My key thought for 2019 is that we need to better understand flows and liquidity pools. Market participant positioning appears to have risk & trading profile of a short option. This adjusts the behaviour of significant market participants and therefore sources of liquidity. Don’t read me wrong, after twenty years in equity derivatives I’m in favour of financial innovation. Financial engineering has developed solutions to help financial platforms deliver for investors, however, we should take note of when this begins to impact the price discovery process on which these businesses sit.

I hope you have found this thought-provoking and interesting. If you would like to discuss this further with me please contact me at stephen@howard-trading.com as I’d really like to hear your thoughts and opinions.