Measuring crowded trades in financial markets
Regulators understand the potential threat of crowded trades, but they also recognise the difficulty of tracking them. This column suggests a new approach for regulators to monitor crowdedness of selected trades. Fund managers and financial regulators could use data on crowdedness to assess the risk that a financial market may enter an asset bubble.
Whether crowded trades pose a threat to financial institutions has been on regulators’ minds for several years. In 2004, Timothy Geithner, then President of the Federal Reserve Bank of New York, put it this way: “While there may well be more diversity in the types of strategies hedge funds follow, there is also considerable clustering, which raises the prospect of larger moves in some markets if conditions lead to a general withdrawal from these ‘crowded’ trades.” The underlying logic of Geithner’s remarks is simple enough. Market participants may face additional risks if many players want to exit similar positions at the same time. Lasse Heje Pederson (2009) has modelled this behaviour in financial markets. When shouts of “fire” are heard in a crowded theatre, patrons face not only the risk of fire, but also the collateral risk of being trampled by others trying to escape the common threat. A stampeding crowd just might kill you even if the fire does not.
Congressional testimony over the last year shows that regulators understand the potential threat of crowded trades, but they also recognise the difficulty of tracking or identifying crowded trades. As one commentator concluded, “the sad truth [is] that crowded trades are difficult for the government to identify” (Mallaby 2009). While there are some data that analysts occasionally allude to as indicators of crowding, no technique has been proposed for identifying which trades are crowded or quantifying the extent of crowdedness.
- Carry: where speculators hold long positions in high interest-rate currencies financed by short positions in low interest-rate currencies,
- Trend: where speculators hold long positions in currencies with positive trend financed by short positions in currencies with negative trend, and
- Value: where speculators hold long positions in highly undervalued currencies financed by short positions in highly overvalued currencies.
Data on crowdedness could potentially be useful to fund managers. Economic intuition suggests that as more speculators move into a trade, prices adjust and expected returns fall for speculators who come afterwards. When investors buy an undervalued currency, at the margin the spot rate appreciates and the currency becomes less undervalued. When investors swap out of low yielding securities for higher yielding ones, there is pressure to shrink the yield differential, lowering expected returns from the carry trade. (See also Jylhä and Suominen 2009). Trend following could be an exception whereby speculators piling into a trend help exacerbate and extend the trend, thereby attracting other trend followers. But under the notion that “trees do not grow to the sky,” trending currencies may become overvalued, making it risky for late arrivers to a trend-following strategy. Knowing that a certain trade had become crowded would likely encourage managers to look elsewhere rather than piling on and adding to the crowdedness and risk of trading style. Indeed, this conclusion is reached by Robert Litterman, managing director at Goldman Sachs Asset Management as reported by Reuters, “Quant hedgies must fish in fresh waters – Goldman,” in December 2009.
Data on crowdedness could potentially be useful to financial regulators. While the private investment community could be self-regulating in the sense that fund managers ought to be wary of entering crowded trades, market regulators could provide an additional brake on private market excesses. Market regulators could independently monitor crowdedness of selected trades with the objective of either making these measures public, or privately counselling individual banks and funds on the risks they are exposed to. Beyond counselling, regulators of course have the option to raise capital requirements for operations deemed to carry greater risks. Measuring crowdedness may offer a useful tool in determining whether a financial market is at risk of entering an asset bubble.