When credit, equity, forex, emerging markets, and even precious metals are all moving as one, “hedged” positions turned into concrete blocks that were tied to daily profit and loss statements - with more losses than profits given recent market upheavals.
Yet when speculators recovered equilibrium, they all went back to the same markets, as if the same thing were not likely to happen next time there is even a mild uptick in volatility, writes Dizard. If hedge funds et al really wanted diversification, they would look further afield.
Where to? Well, take electricity trading for instance. Not just the contracts traded on futures exchanges in the US, but on the electronic markets that are now run by the authorities that manage electric grids, known as Regional Transmission Organisations, or RTOs.
The second largest RTO is the Midwest Independent System Operator. A non-profit company based in Indiana, it manages the transmission system in a 13-state region and controls the dispatch of more than 137,000 megawatts of power generation. Miso administers trading for three products: a “virtual”, or cash-settled day-ahead market for electric power in the 1,500 “nodes”, or delivery points on the system; a “real time”, or physical market, for power on the day of delivery; and a market for “financial transmission rights”, another cash market that allows generators or load-serving utilities to hedge the price risk of congested power lines.
The essential problem is that electricity cannot be easily stored and is produced and delivered by large lumps of capital in the form of generators and power lines. The function of Miso’s markets from the point of view of the public interest is to break up the monopoly power of the capital owners, allow for efficient price discovery and lower the overall cost of electricity. The function from the trader’s point of view is to provide arbitrages and speculative opportunities.
Since Miso’s markets started operating in April 2005, both sets of objectives have been met. Miso end-user costs are lower, reliability is higher and some traders are making a lot of money.
Likes James Williamson, who started out with $25,000 in collateral for the Miso clearing system and expenditure of about $5,000 on used computers and software. He now has a net worth in the low seven figures and employs a handful of people in his office outside Denver, Colorado. In addition to trading the Miso market, he trades in the Texas and California electric markets and has enough collateral to trade on the ICE electronic energy exchange. He has also increased his collateral posting on Miso to $150,000, though, as he says, “there are ways to manage your position so the credit risk the system measures is minimised. On that amount of credit, I expect to make about 2,000 per cent annually.”
Of course, the business requires an obsessive attention to detail and a careful eye on regulations and Miso’s business practices. How can he compete with the likes of Morgan Stanley or UBS?
“The markets have proven a lot more insensitive to trading volume than I would have thought,” he says. “My advantage is that I can spend all my time trying to make money, not sending e-mails or stuff like that. In the stock market, if you see a pricing inefficiency it will be hit by a computer program in seconds. Here you can have [arbitrages] that last for days. There is just so much fruit lying on the ground here.”
One might add that it is fruit that has little correlation with other markets. What matters are generator outages, weather and congested transmission lines, along with seasonal use patterns.
Why don’t larger institutions get more involved? “If you don’t make $50m a year in a bank you’re nothing. You can make $15m or $20m, but that’s small in a big bank,” Mr Williamson says. It is more, though, than the negative figures that a lot of hedge fund partners will receive in the post next month.
If the power trade doesn’t spark your interest, there’s always wine. Just don’t forget to invite FT Alphaville round for a sip of the profits.
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