Where Have All the Volumes Gone?

During and after the 2008 Financial Crisis extreme volatility caused volumes on listed exchanges to EXPLODE setting continuous annual records through 2011. As a result of this tumultuous period, market participants migrated from Over-the-Counter (OTC) markets to regulated listed derivatives exchanges where liquidity remained deep, transparency was great and counterparty risk was reduced, causing a tremendous run-up in volumes. Leading up to the crisis, complacency was rife throughout the trading world as many partakers expected recent price trends to continue higher into perpetuity (Can you say “It’s different this time”….Really!!!). Consequently, participants didn’t see a need to incorporate derivatives into their strategies to hedge against potential adverse price movements, but that behavior soon changed as well, which also contributed to the increase in volumes.

Derivatives are no longer a dirty word and are commonly used in some of the most conservative portfolios across a multitude of asset classes. Derivatives are used not only to protect against Black Swan (random and unexpected) events but also to enhance returns through various call writing option strategies, BXM for instance http://www.cboe.com/micro/bxm/introduction.aspx . Despite Warren Buffett’s dire warning to the masses regarding the use of derivatives (remember….”they’re like playing with weapons of mass destruction”) professionals and amateurs alike are embracing these tools more than ever….well, up until 2011 anyway. 

2012 shaped-up to be a less than banner year for most exchanges. Even though volumes remain well above pre-crisis levels they have decreased dramatically from their 2011 peak. The Options Industry Council (OIC) recently reported that total equity options volume for the entire industry was down 12.85 percent from 2011, the first year-over-year decrease since 2002 (volume was above 4 billion contracts for the second straight year); CBOE’s performance was exceptional, relatively speaking and outperformed the industry by nearly 6%. Regarding futures volume the CME reported a decrease of 15% and in the cash equities space both NYSE and Nasdaq were down 27.3% and 15.2%, respectively…..OUCH!!! One bright spot however was the CBOE Futures Exchange (CFE) who posted a record year and saw their volumes nearly double (thanks to VIX and geopolitical uncertainty) http://ir.cboe.com/releasedetail.cfm?ReleaseID=731124 . Even with the recent pull-back in volumes I believe derivatives are here to stay and are finally receiving the respect and notoriety they deserve.

To help explain the anemic results we need to identify a few significant industry events that may have adversely affected investor psyche which provided strong enough head-winds that contributed to the reduction in volumes. Let’s begin with a few of the most noteworthy events that have shaken investor confidence to the bone……Initially there was the staggering financial collapse of the equity and credit markets, erasing more than 50% of the stock markets value. Bankruptcies of Lehman Brothers and MF Global also contributed to the deterioration of investment sentiment, as well as the botched episode of Facebook’s IPO (the icing on the cake). High profile events arising from asset managers such as Madoff and Peregrine Financial and from Institutions that may have structurally manipulated LIBOR, an interest rate benchmark used to settle trillions of dollars of fixed income vehicles that directly or indirectly impact most consumers, provided further skepticism. The Federal Reserve’s economic stimulus program – Code Word(s): Quantitative Easing 1 (QE 1), QE 2, QE 2.5, Operation Twist, and QE to infinity……., all of which artificially alter interest rates making fundamental analysis that discounts future cash flows nearly impossible to accurately value assets, another form of manipulation which deters market participation. Finally, Dodd Frank, financial regulation which is coming down the pike and is in the process of being finalized and is causing grave uncertainty resulting in business decision “paralysis”. This legislation is responsible for the divesture of proprietary trading desks and the deleveraging of bank assets. Overall, this magnitude of risk reduction is, and will continue to have an adverse effect on volumes.

Wow! That’s really a lot for any industry to endure in a relatively short time horizon. The good news is most (I said most……Not Dodd-Frank) of these issues are behind us. However, the bad news is no one knows how long the healing process will take to restore investor confidence or when the business climate will improve in order to resume the industry’s path to pursue new volume records.

John Angelos

CBOE