Are Market Mechanisms Failing?

via The Finance Professor:

Previously, we talked about money being electronic, and, if the power goes out, its game over for the monetary system. Recent news items are disturbing in that a few markets have failed. For example, Russian capital markets failed and you can't trade Russian securities in either London or New York. That is worrisome. Second, Bloomberg is reporting that Schwab & Fidelity brokerage clients can't exercise their long put options on Russian securities. THAT is really worrisome. Typically when a security is halted, you can still exercise your long puts, as the brokers just assign the short put position with a short position in the underlying instrument. The Options Clearing Corp (the OCC) is not going to automatically assign positions that are expiring in the money, which is a deviation from normal procedure.

The piece de resistance was the LME cancelling trades in Nickel on March 9th, effectively bailing out a number of speculators. The London Metal Exchange, bless its soul, is an old fashioned pit trading system with a circle of red sofas, with elites in the middle and others in the rear (spectators in the upper right balcony). The LME is owned by Hong Kong Exchanges & Clearing Corp, and the largest speculator on the wrong side of the Nickel trade was Tsingshan Holding Group, a Chinese nickel producer. You can see where this is potentially going. Russia being cancelled is one thing, but what happens when China gets cancelled? Is China too big to fail?

Precedent is elucidated in an interesting story from WW1 on globalfinacialdata.com. On July 31, 1914, stock market trading was suspended in both London and New York. Its a chilling read, but, in summary: the NYSE was closed for over 4 months and the UK government restricted capital flows out of the country & also forbid equity issuance except those in the national interest. Exchanges in St. Petersburg and Berlin fared even worse.

The massive amount of intervention suggests that yes, markets are indeed failing. Who do you think owned the $16 trillion of bonds trading at negative rates? Its pretty obvious that if you wanted a banking license in Europe, you needed to hold the government's bonds at a guaranteed loss - that is the licensing tax and a pretty massive indicator of a failing market.

Don't be surprised if there is another flash crash and trades are cancelled in response. Either way, the capitalistic system of the past 80 years is starting to crack. Brokers like CSFB should not have been hit by Archegos, but they were. Its a decade old now, but Knight Group was trading 17% of both the NYSE and Nasdaq when it failed in less than 30 minutes in 2012. That is a mini-market failure.

We suspect that the biggest potential market failure is possibly global trade itself. The expansion of global product markets has been an unprecedented boon to all economies. Cancel culture and increased geopolitics could result in a second cold war fought through trade restrictions. This has massive implications for investors. Many leading multinationals do 70% of their revenue abroad, and others import a huge amount of goods. These are great companies and great stocks, but what happens to them when the world gets closed down?

McDonalds was fine on Feb 22nd, then Russia happened, and it sold off hard. Being large and multinational is usually a good thing, but investors at least need to consider the possibility of China getting cancelled. China too big to fail or be cancelled? Think again. Over the past 3 days, China has been shutting down major regions due to its strict Covid policy.

Investors should make their own optimal decisions, but it might be a good time to research homebuilding stocks or buy that local apartment building.