Our colleagues on the paper-side drew attention last week to the fact that silver trading in Asian hours experienced a clear pickup into the lead up to the commodity rout.
Jack Farchy wrote, citing Edel Tully, analyst at UBS:
At the same time, silver turnover on the Shanghai Gold Exchange, China’s main precious metals trading hub spiked, rising 2,837 per cent from the start of this year to a peak of 70m ounces on April 26, according to exchange data. The number of contracts outstanding, an indicator of investor exposure, doubled over the same period.
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“I’m pretty certain it’s the Chinese retail [investment] that is driving this move,” one senior precious metals banker said. “There’s an enormous amount of speculation going on out there, they’ve got the bit between their teeth.”
This has now got Eric Burroughs at Reuters thinking about a possible “Asian connection” to the commodities surge and subsequent rout, as well as the role of ETFs.
As he noted late last week:
The other question is the role of ETFs. Some of the most volatile swings in silver and oil happened in less-liquid Asian hours. Asian trading is a time when any big buyer or seller would almost certainly avoid stepping in, knowing full well that liquidity is not what it is during New York and London hours. Computers obviously have fewer such compunctions.
Metals traders in Asia blamed ETFs for the sharp silver selloff. To be honest, I don’t know how ETFs trade into market moves in a 24-hour market cycle, given the need to track index performance. It’s something I’ll be following up on.
But are ETFs pro-cyclical traders in illiquid market moves? Are humans or computers making the trading decisions? Are the algos able to make split-second liquidity trading decisions? ETF prospectuses don’t give much clarity on how they trade, other than warning about liquidity as one market risk.
But the rise of ETFs, especially leveraged ETFs, only appears to be adding to the liquidity risks now gripping markets. The Financial Stability Board recently noted the risks from ETFs, especially those that provide on-demand redemption and liquidity but deal in less-than-liquid markets (think silver): ”The expectation of on-demand liquidity may create the conditions for acute redemption pressures on certain types of ETFs in situations of market stress, which could in turn affect the liquidity of the large asset managers and banks active in this market.” And of course flash crashes in commodity markets don’t just affect professional investors, thanks to ETFs.
Now, before we comment on the ETF component to the argument, it’s worth looking at the data. That’s the data we can get our hands on, which is mainly via the CME in the form of out-of-hours metals and energy futures volumes.
Arguably, it did see a pick-up in Asian volumes relative to European vols from March to April.
In energy there was a boost in the Asian time periods — though the overall sums were still lower in April than in March:
In silver, the trend was much better observed:
Though, if you compare April’s figures to those from last year, the boost in overall metals volumes is clearer still.
So there is some basis to the idea that someone somewhere has been making more use of futures, specifically silver futures, over the Asian trading session.
As to the role of ETFs, we’ve asked around. It seems if there is a role, it’s probably via the over-the-counter trading market. According to informed parties, there are generally two types of market makers in this sphere — those that use statistical arbitrage strategies focused around making the most of out-of-hours trading, and those that run pretty low risk high-frequency trading models around mispricings between the underlying and the ETFs. Some do a bit of both.
Though in the case of the former, if there aren’t enough competing market makers in the out-of-hours market, there is the chance that their prices might take advantage of that. As we were told:
How close they are to fair value, that will be a function of the level of competition. If you only had one market maker making prices out of hours, efficiency would be quite low. If more competition prcies would be more fair.
The other point to make is that market makers and authorised participants of ETFs are known to use futures for hedging purposes. If the cost of using those futures rises — say, because of margin hikes — that can influence them to drop the use of futures in favour of other techniques.
As Kris Walesby, head of capital markets at ETF Securities told us:
When trading volumes for an ETP are high, market makers are more easily able to use other strategies to come out of the position, for example, they could use competing market maker prices, which had not caught up.
In other words, it may incentivise HFT strategies since to be able to buy and sell onwards to a so-called ‘stale’ quote, you have to be quicker than your competition in moving your own prices. If one is faster than the other they can buy against the investor and get out by selling to an market maker that hasn’t moved their price yet.
Meanwhile, if the trading is more one sided — say more selling than buying — and the price is going to the downside, then it might still be difficult to balance their positions out. In which case, we are told, their strategies might include a mixture of futures and the speed of other market makers.
Either way, the result is potentially a dangerous mix of high frequency trading in illiquid, out-of-hours underlying commodity markets.
Related links:
It wasn’t the ‘froth’ that caused the commodities rout – FT Alphaville
ETF investors mistimed the commodity correction (again) – FT Alphaville
Commodities rout – Mark 2 - FT Alphaville