The challenge of meeting a huge demand for safe investment vehicles

Anyone who has noticed how bond demand since 1Q 2007 has kept the U.S. retirement fund industry its asset acquisition in the black will understand that retail investors have not stopped clamoring for safe trading/investment instruments. A similar move is afoot in the ETF world, where bond ETFs now comprise 14% of all ETF assets – up from 5% at the end of 2006. 

Wait a minute, are we not entering a growth stage that should favor stock demand? I have discussed in other blog entries how macro events are setting the stage for continued investor concern, but there is one new element that threatens for this negative spiral of investor confidence to continue. Banks, the traditional creators of financial instruments, are understandably in bunker mentality.

Yes, the Volker rule, stagnation in OTC derivatives regulations, ring-fencing plans in the UK, (out-of-touch) high-frequency trading/short-sell-bans rules from ESMA, and new rounds of bank recapitalization requirements seem to be having a bit of an impact on bank trading ops (JP Morgan, Goldman Sachs, etc).

But let’s face it. Without market makers and prime brokers offering credit lines and attractive prices to brokers, there is no hope for any of us – institutional and retail traders included – to benefit from participation in a liquid markets.

Do we really want all of our online trading markets to be so void of volatility as the dollar-yen or the euro-swiss are today, or CDS spreads that illiquid and useless? These types of trading lulls are deceiving because they hide sharp adjustments that will likely come at the worst possible times, when the regulators who are ‘protecting’ these low volatility environments find themselves most vulnerable.

MISGUIDED HOPE

I have this misguided hope that one day our capital markets will have a robust set of investment/trading selection in investments that channel investor fears. Rest assured, I can safely state that there will never be a shortage of investments catering to investor greed – dot.com stocks, CDOs, etc.

Among investors/traders’ darlings in times of fear are, not surprisingly: the U.S. dollar, select government debt instruments (U.S., Germany, Japan), and gold. Besides these, there is little else that has sufficient good faith and liquidity to be tradable in times of crisis.

An upcoming Aite Group report I am working on quantifies the level of hoarding/adoption for these types of instruments among those with more than US$25,000 in investable assets. But it should stand to reason the most basic law of economics.  Whenever the supply of a good is a fraction of its demand, prices for that good will inevitably rise.

My contention is that these selective rises in prices compound problems for all remaining capital markets instruments. We saw this in the aftermath of the European exchange-rate-mechanism (ERM) blowup in 1992 and there is a prospect for that in the coming year.

Let’s stop creating new bubbles and new distortions through inaction. It is time to start putting forth the best our financial engineering can muster to create investing/trading vehicles which can satisfy the high threshold of confidence scared investors demand. A wink from regulators and the financial press will go a long way for banks to find enough reprieve to develop such instruments.