Monday, November 14, 2011

biggest market mover -- not a large number of small players

(need a better title...) When people say things like

"the market has discounted ...", or
"the market has priced in ...", or
"the market rejected ...", or...

they seem to suggest a large number of roughly equal players collectively feel a certain way and the resulting market price[1] reflects their collective reactions, interpretations, outlook and sentiment. (Some may argue that the result reflects 2 camps -- bears vs bulls.) But I feel it's naive and simplistic. Often market price is (legitimately) influenced by a small number of power players.

Case in point - The largest markets -- currency, interest rates, sovereign debt -- are supposed to be the hardest to manipulate due to sheer sizes, but are actually influenced by a few individuals in big hedge funds and governments, people like Soros.

People tell me investment banks are not prop traders and legally restrained from hedge-fund tactics, so these people feel i-banks actually have less influence on these markets. I am skeptical. Big banks operate at the center of "information vortex", an enviable position of influence. They WILL exploit it.

Speaking of forex, how about the non-speculative "hedgers" -- like big multinational corporations who transact in multiple countries? I feel they aren't in the business of moving billions of dollars everyday to manipulate market, (though they move billions annually). I might be uninformed.

In a typical forex market, a 100mio [3] order is likely to cause market impact as it sweeps up a lot of limit orders on the other side. I feel many players have the credit limit to send 100mio orders. If a forex rate gains some pips over 24 hours, it might be due to such orders. However, these effects are still small and temporary -- A forex rate often shifts 20% over 12 months.

[3] this figure is mentioned by some FX veterans in 2011. It's documented since the 90's that a single large trade by a corporation CAN indeed move the best bid/ask, at least in the short term.

Another factor to market movement is information asymmetry. Information is key to investor behavior. Big players gets more information. They radiate and manipulate information while small players largely receive (then filter) information. Among the consequences, a large number of small players can be influenced to buy/sell a security and therefore move a market.

Let's ignore herd instinct[2]. In any market with a standard order book, the mid-price is the most prominent but its design gives a lot of influence to a single player with deep pockets. All the smaller players can be sidelined quite easily.

[2] (which is the more important reason big players can influence a market).

Case in point - Commodities markets are influenced by big suppliers/wholesalers, and to a lesser extent big investment banks.

Case in point -- Corporate securities - bonds, stocks, CDS - are easier to influence and susceptible to manipulation.

[1] Note the one numeric indicator referred to is .... the oscillating mid-price. In these statements, "The market" actually has a more complete meaning including
- depth of market -- sizes of "next best" quotes
- all the recent trades in that security
...but it's ok to simplify everything to a single number.

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