FT Alphaville is reading Robert Harris’ The Fear Index at the moment, and would like to take this opportunity to recommend it as required reading for anyone who enjoys a good Jason Bourne style adventure, especially when set in the context of modern market meltdowns.
Though, it’s actually come to inspire the plot to our very own action-packed markets adventure, one we’re calling “Dark inventory: The ultimate financial frontier.”
Though our book isn’t necessarily fiction. The outline goes as follows.
Dark inventory: Inventory that’s out there, but which no-one else can see.
It comes in many shapes and forms.
Equity inventory, which has been internalised by banks and parked off-balance sheet (appropriately via private dark pools). Copper inventory, which has been stashed off-market and encumbered via finance deals. It’s also yet-to-be-produced commodities which have been pre-sold, but which nobody else knows have been encumbered.
But if you have the power to see or command the darkside inventory, you have the power to stay ahead of the game. Especially if you can move quickly.
Indeed, almost every befuddling market move of late can, if you think about it, be explained by the concept of dark inventory.
For example, consider the impact of dark inventory accumulation (the possible consequence of cheap liquidity).
In oversupplied markets this can mislead fellow investors. They see buying interest coming from somewhere, though they can’t quite understand from where. The fundamentals don’t explain it, but prices are rising regardless, led usually by the cheapest securities, and in tandem. With no ability to see the dark inventory, the market finally falls for the trend. They believe the demand is real.
If you are the accumulator of dark inventory, or privy to the flow, you are able to foresee the market rallies and position yourself accordingly. This is a profitable time.
Of course, in continually oversupplied markets you will begin to suffer the costs of hedging inventory, if you are bothering to hedge, (since forward curves may eventually flatten out) as well as the burden of balance sheet expansion. Eventually it will make sense to park that inventory off-balance sheet. Thanks to matching, aggregation and netting you can use the inventory (in a sliced up, mixed up manner) to back equitised structured products, exchange traded notes, exchange traded products as well as synthetic funds. Lots of launches follow. This especially makes sense if by then everyone is a believer in the rally, a fact which has translated into genuine buying interest which can now be captured to back your dark inventory.
The game is afoot.
Now and then, you might feel inclined to take a little profit. You will want to overwhelm the market with a small release of dark inventory into what is a very finely balanced and thin public market. Since you have the power of foresight, you can position yourself to profit from the impact of your move.
You might do this in one big dump, or you might do it successfully throughout the day, firing the dark inventory in a manner that earns you tiny basis points on millions of fresh buy orders.
Overall, your profit-taking strategy will see you dumping stock in rising markets, and buying in falling ones. Risk on, risk off. Your accumulation and dispensation of assets will be counter-intuitive to market sentiment.
But since not everyone is a believer in the rally, shorts will also be accumulating. These shorts will serve you well when you want to give the market a pop. Every time there is even a whiff of a fall, you will try to overcome the shorts with large buy orders, shaking them out, or ideally causing some genuine squeezes.
The danger comes in over-estimating the size of the shorts and having your dump-and-buy strategy overwhelm the market. With no shorts for support, and no other buying interest present in the hugely thin public market, the proverbial floor will be lifted. The result, of course, is a flash crash-esque price crash, which won’t recover until the second leg of your strategy — the continued buying bit — kicks back in.
But the strategy does have one major vulnerability — it only works for as long as you have access to cheap financing for the accumulation and maintenance of your dark inventory in downside markets. If you run out of financing, you will be restricted on how much more stock you can buy to support the market. This is especially the case if you can no longer find appetite for your off-balance sheet vehicles.
If sentiment changes markedly at the same time — that is, leads to fund buyers actually pulling out and removing support from pre-existing dark inventory — you may even be forced to start liquidating back into the market, if you can’t raise cash to return to investors elsewhere. Though you’ll want to do this in as strategic a way as possible, especially if markets are now falling fiercely. While you wait for any upside momentum to dump stock into, you may find yourself overcome by a liquidity short-fall due to the need to satisfy redemption requests.
In commodities, which operate more slowly, the unwind can at least be managed more effectively. For one thing, it’s easier to fool people into thinking that destocking of public inventory is a symptom of more demand. So, even if prices are failing to rally, any sniff of backwardation or a relapse into more stockbuilding status brings in short interest — positioning itself to profit from a switch back to oversupplied status and the return of contango.
They are not wrong. They have just timed their positions incorrectly since they are unaware of all the yet-to-be destocked dark inventory. For the dark-inventory holders, this is one last chance to eliminate the float, especially if they can encourage a squeeze in the market, using the rallies to destock dark inventory for as good a price as they can fetch. The result is rising volatilty and a whipsaw market.
What happens next?
Unless real demand actually kicks in, then the remaining inventory will have no choice but to be forced out. If all the willing shorts have been suckered out — because it’s become impossible to time short positions profitably, and too costly to ride upswings — that will once again lift the proverbial floor on prices when the inventory is finally offloaded. Then it’s just a matter of how low things can get before genuine buyers step back in and markets are released from the power of the dark inventory.
What does this lesson teach us?
Possibly that in ever more technologically-advanced markets — a fact which should be driving transparency and price efficiency — there’s always a clear interest in obscuring fundamentals to stay ahead of the game. In fact, if you are an intermediary, it may be the only way to justify your existence in a world which would otherwise be too efficient to need you.
Which means if the fundamentals triumph regardless, a brave new world of finance could soon be upon us — one where technology has eventually cut the intermediaries out of the game.