Extreme volatility resulted in high transaction volumes in 2008 – a trend that is unlikely to continue.

During the latter part of 2007 and all of 2008, overleveraging and financial services risk spilled over into the mainstream economy, creating widespread uncertainty. These conditions caused the markets to go into wild convulsions. Exchanges benefited from the volatility because volumes exploded, but experts say that in 2009 such high volumes are unsustainable.

Risk and uncertainty drive volatility, which affects particular companies and industries as well as the general economy. Since the financial crisis began, some sectors have been more volatile than others. On a continuum, financial services would be at one end of the spectrum and low cost consumer staple goods at the other. Between late spring and fall 2008, the share volatility of Bank of America and Citigroup went up 10 times, whereas the share volatility of giant retailers Wal-Mart and Costco merely doubled.

Normally, one or two asset classes might experience high volatility simultaneously. But this time, there were wild price swings in almost all asset classes. At the height of the global financial crisis, the Chicago Board Options Exchange Volatility Index (VIX) moved from about 20 in the summer of 2008 to as high as 80 in the fall. During the same period the dollar rose approximately 10% against the euro, oil declined approximately 72%, and the Dow Jones Industrial Average fell about 24%.

“That translated into business uncertainty because companies have to buy raw materials, sell products, and raise capital,” says Frank Hatheway, Senior Vice President and Head of Economic & Statistical Research at NASDAQ OMX. “The uncertainty, in turn, led to a freeze in economic activity in September and October.”

To this end, recent investment decision making has been based on emotion – fear to be exact. Traditional buy and hold investors liquidated riskier positions and fled to cash. Speculators both bought and sold aggressively depending on the latest news or rumor from around the world. These massive crosscurrents resulted in much higher trading volumes and contributed to heavy intra-day volatility.

Generally, there has been a strong correlation between exchange volumes and volatility, although it is not clear which is the cause and which the effect. Volatility may increase exchange volumes at least in the short term. Market swings prompt investors to adjust and reallocate their positions, while day traders seize opportunities to benefit from these movements. In declining markets, selling pressure isexacerbated as exchange members liquidate the positions of clients unable to meet margin calls.

Interestingly, volatility caused buyside traders to shy away from crossing networks. “They are highly sensitive to the possibility of looking very wrong and very stupid if they put up too much stock at the wrong price,” says TABB Group Senior Consultant Laurie Berke. “There was a need to use more caution, increased use of limits, and orders were left for a shorter period of time.”

As the equities market declined during September and October, higher implied volatility led to an increase in exchange-traded options volumes. But according to Tomas Bernholm, Head of Exchange Brokers – Derivatives Markets at NASDAQ OMX Nordic, continued high volatility could suppress volumes over the long haul. He points out that institutional investors have been the significant force behind the growth in the options market, but some firms are only allowed to take long positions. When volatility goes up, so does the price of options. Theoretically, if options become too expensive, investors will not buy them because they perceive the price of the risk is too high.

Investors who are permitted to sell options will do so when implied volatility is high and they expect it to decline. However, options writers have to put up collateral against their positions. When volatility is high, so are margins, and this could potentially deter investors from opening new positions.

Similarly, increased volatility will probably lead to lower equities trading volume in the long term because investors will become risk averse and choose to remain on the sidelines until the market stabilizes. It may take a year or more to filter through, but that is the likely scenario for 2009 as we move our way through the financial crisis.

“Volatility will come down off its peak, but it will stay much higher than during 2004-2006, when the VIX was in the range of 10-12,” Hatheway predicts. “At the same time, volume will likely come down with it.”

The two bear markets at either end of the ‘70s are the precedent for this scenario. It took three years for volumes to recover after the second oil shock in 1979. Similarly, it could take until the end of this decade before investors and statistical arbitrage players return to the market.

One lesson exchanges learned from recent experience is that they can never have too much capacity. All the US exchanges were able to handle the volume demands even as they used much of their spare capacity on high volume days. That some secondary data feeds ran slowly or went down also needs to be addressed.

The infrastructure for algorithmic trading – including the routing parameters and cancel/replace functionality – held up. “Algorithms withstood the test,” says Berke.  There’s a solid confidence now in the ability of the infrastructure to manage markets in which there is extreme volatility and volume.”
 

Exchanges’ risk management models and clearing systems were put to the test, and they worked. “Exchanges figured out they had to increase margins early to avoid defaults, and to keep a close watch on both the members and the market, especially in illiquid stocks and instruments,” adds Bernholm.

Another key takeaway is the importance of markets staying open. Investors might not have liked the price, but they could still buy and sell equities and exchange-traded derivatives. The fact that there was liquidity provided some confidence when the credit and other markets were freezing up.

Ultimately, exchanges are among the few market players that have come away from the financial crisis relatively unscathed. The challenge going forward will be to find ways to capture revenue in the face of potentially declining volumes.

BY Sherree DeCovny ILLUSTRATION ANNA SVANFELDT