Volatility and risk are of central importance to those of us involved in finance. But there is a great deal about them that we do not understand. Even more critically, there is quite a bit about volatility and risk that we think we understand but do not. I believe we have lost sight of the fact that risk is not the only contributor to volatility.
Risk has a well-defined meaning to economists: It exists when an outcome can be described as a draw from a probability distribution with known parameters. But along with risk, there is also uncertainty. With uncertainty, we do not know the probability distribution. We might not even know what all of the outcomes are. Dealing wisely with uncertainty is a huge challenge. In my opinion, we have not paid sufficient formal attention to uncertainty as a cause of volatility.
High volatility has been with us for more than a year now. I am not referring to price fluctuations over lengthy, multiyear periods. I am thinking of the very appreciable volatility that we experience, day after day, on an intraday basis. Price changes of 1 percent, 2 percent or more are common. A 1 percent daily price move, annualized, translates into a 250 percent change. We do not see annual swings of this magnitude very often. In the opening and closing minutes of trading, intraday price movements are even more accentuated. Why?
Reason number one has to do with price discovery. Share values are not found in the offices of the stock analysts, but are discovered in the marketplace. Share prices do not follow random walks, and they are not simply and uniquely linked to “the fundamentals.” How can they be when, in the face of enormously complex and imprecise information, investors form diverse expectations of future corporate performance and thus, at any current moment, evaluate shares differently?
Good price discovery is very difficult to achieve, especially when some investors are influenced by what they see other investors doing. That is when we get information cascades and herding, that is when a market can get into trouble, and that is when inaccurate price discovery can contribute mightily to volatility.
Reason number two has to do with liquidity creation. In research done jointly with Asani Sarkar of the Federal Reserve Bank of New York, we have found that markets are generally two-sided, and that two-sidedness holds under a wide range of conditions. Sidedness refers to the extent to which buyers and sellers are both actively present in a market, in roughly equal proportions, in brief periods of time (e.g., five-minute intervals). Asani and I have found that two-sidedness holds for both Nasdaq and NYSE stocks; at market openings, midday and at the close; on days with news and on days when there is no major news; and for both large orders and small orders.
But markets are not always two-sided. At times, liquidity dries up on one side of the market, and volatility spikes. Information cascades can take over, and a market can become one-sided. And when prices suddenly head south, one-sidedness is accentuated as buyers simply stand aside.
Illiquidity is a cause of volatility, and its counterpart, liquidity, does not just happen. Liquidity creation is a process. There is a good deal more that we need to learn about the dynamics of liquidity creation. As we all know, opacity is needed by the big players. The large traders seek the protection of opacity by either turning to a dark pool or, when going to a more transparent limit-order-book market, by slicing and dicing their orders so as to hide them in a stream of retail flow.
Opacity is one thing; fragmentation is another matter. Whether liquidity pools are light or dark, fragmentation can disrupt the natural two-sidedness of markets. In my opinion, the real concern about the dark pools of today is not that they are dark, but that connectivity may not be a viable substitute for consolidation.
And then there is the temporal dimension of fragmentation. I have for a long time been a proponent of electronic call auction trading as an order-consolidation, price-discovery mechanism. Calls should be included in our predominantly continuous trading environment to open and to close markets. A call, by amassing liquidity at specific points in time, can do much to contain excessive volatility.
Other key market structure features are circuit breakers and volatility interruptions, which are used in Germany. In my opinion, volatility interruptions, which are brief, firm-specific trading halts, have some very desirable properties.
There is another solution to the problem of extreme market turbulence. After the Crash of ’87, I proposed the establishment of voluntary stabilization funds that would buy and sell equity shares according to a strict and well-defined procedure. A fund could be established by a listed company itself and run by a third-party fiduciary. Shares of the company’s stock would be bought by the fund in a falling market and sold by the fund in a rising market at pre-specified price points, in pre-specified amounts and, very importantly, in call auction trading only. This voluntary procedure would disrupt herding, bolster the two-sidedness of markets and help to contain the bouts of sharply accentuated volatility that we can experience at any time, and that have been with us in full force since Labor Day. The proposal was published 20 years ago in the Fall 1988 issue of the Journal of Portfolio Management. I still believe in it.
This year we have been hit by tidal waves of volatility. Two structures have to be strengthened to address the problem: market structure and regulatory structure. At this point, regulatory structure may well be the more challenging of the two. Regulation is indeed needed, but it must be appropriate. The issues, the concerns, the market inefficiencies upon which regulations should be based must be better understood. And regulatory inefficiency must also be taken fully into account. Excessive regulation and/or ill-structured regulation can be extremely costly to financial markets in particular and to society overall.
Hopefully, after the dust has settled, both market structure and regulatory structure will operate more effectively. In the meantime, one thing is for sure: The financial turbulence of 2008 has given us all a great deal to think about.
Robert A. Schwartz is the Marvin M. Speiser Professor of Finance at the Zicklin School of Business, Baruch College, CUNY. He adapted this piece from his remarks on volatility delivered at his financial markets conference on Oct. 23, 2008.
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