How Market Complexity Could Trigger the Next Crash
Complex systems are all around us.
By one definition, a complex system is any system that features a large number of interacting components (agents, processes, etc.) whose aggregate activity is nonlinear (not derivable from the summations of the activity of individual components) and typically exhibits hierarchical self-organization under selective pressures.
In today’s infographic from Meraglim we use accumulating snow and an impending avalanche as an example of a complex system – but really, such systems can be found everywhere. Weather is another complex system, and ebb and flow of populations is another example.
Markets are Complex Systems
Just like in the avalanche example, where various factors at the top of a mountain (accumulating volumes of snow, weather, temperature, geology, gravity, etc.) make up a complex system that is difficult to predict, markets are similarly complex.
In fact, markets meet all the properties of complex systems, as outlined by scientists:
System actors have different points of view. (i.e. bullish, bearish, long, short, leveraged, non-leveraged, etc.)
Capital markets are over-connected, and information spreads fast. (i.e. chat rooms, phone calls, emails, Thomson Reuters, Dow Jones, Bloomberg, trading systems, order entry systems, etc.)
Trillions of dollars of securities are exchanged in transactions every day (i.e. stocks, bonds, currencies, derivatives, etc.)
4. Adaptive Behavior
Actors change their behavior based on the signals they are getting (i.e. making or losing money, etc.)
And like the avalanche example, where a single snowflake can trigger a much bigger event, there are increasing signs that the complexity behind the stock market has also reached a critical state.
Markets in a Critical State
Here are just some examples that show how the market has entered into an increasingly critical state:
The VIX, an index that aims to measure the volatility of the market, hit all-time lows this summer.
Bull Market Length
Meanwhile, the current bull market (2009-present) is the second-longest bull market in modern history at 3,109 days. The only bull market that was longer went from the 1987 crash to the Dot-com bust.
Valuations at Highs
Stock valuations, based on Robert Schiller’s CAPE ratio (which looks at cyclically-adjusted price-to-earnings), are approaching all-time highs as well. Right now, it sits 83.3% higher than the historical mean of 16.8. It was only higher in 1929 and 2000, right before big crashes occurred.
Market Goes Up
Investor overconfidence leads investors to believe the market only goes up, and never goes down. Indeed, in this bull market, markets have gone up 67 of the months (an average gain of 3.3%), and have gone down only 34 months (average drop of -2.6%).
Here are some additional signs of systemic risk that make complex markets less stable:
- A densely connected network of bank obligations and liabilities
- Over $70 trillion in debt added since Financial Crisis
- Over $1 quadrillion in notional value of derivatives
- Non-bank shadow finance through hedge funds and securitization make risk impossible to measure
- Increased leverage of banks in some markets
- Greater concentration of financial assets in fewer companies
In other words, there are legitimate reasons to be concerned about “snow” accumulation – and any such “snowflake” could trigger the avalanche.
In complex dynamic systems that reach the critical state, the most catastrophic event that can occur is an exponential function of scale. This means that if you double the system, you do not double the risk; you increase it by a factor of five or 10
– Jim Rickards, author of Road to Ruin
The Next Snowflake
What could trigger the next avalanche? It could be anything, including the failure of a major bank, a natural disaster, war, a cyber-financial attack, or any other significant event.
Such “snowflakes” come around every few years:
1987: Black Monday
The Dow fell 508 points (-22.6%) in one day.
1994-95: The Mexican peso crisis
Systemic collapse narrowly avoided when the U.S. government bailed out Mexico using the controversial $20 billion “Exchange Stabilization Fund”.
1997: Asian financial crisis
East Asian currencies fell in value by as much as -38%, and international stocks by as much as -60%.
1998: Long Term Capital Management
Hedge fund LTCM was in extreme distress, and within hours of shutting down every market in the world.
2000: The Dotcom crash
Nasdaq fell -78% in 30 months after early Dotcom companies crashed and burned.
2008: Lehman Brothers bankruptcy
Morgan Stanley, Goldman Sachs, Bank of America, and J.P. Morgan were days away from same fate until government stepped in.
Shelter from the Avalanche
The Fed and mainstream economists use equilibrium theory, regressions, and correlations to quantify the markets. And while they pay lip-service to black swans, they don’t have a good way of forecasting them or predicting them.
Markets are complex – and only complexity theory and predictive analytics can help to shed light on their next move.
Alternatively, investors can seek shelter from the storm by investing in assets that cannot be digitally frozen (bank accounts, brokerage accounts, etc.) or have their value inflated away (cash, fixed-income). Such assets include land, precious metals, fine art, and private equity.
The Making of a Mammoth Merger: Charles Schwab and TD Ameritrade
A look at the histories of Charles Schwab and TD Ameritrade, what comes next after the merger, and the potential impacts on the financial services industry.
Charles Schwab and TD Ameritrade: A Mammoth Merger
In this era of fierce competition in the discount brokerage space, scale might be the best recipe for success.
Charles Schwab has once again sent shockwaves through the financial services industry, announcing its intent to acquire TD Ameritrade. The all-stock deal — valued at approximately $26 billion — will see the two biggest publicly-traded discount brokers combine into a giant entity with over $5 trillion in client assets.
Today we dive into the history of these two companies, and what effect recent events may have on the financial services industry.
The Evolution of Charles Schwab
1975 – U.S. Congress deregulated the stock brokerage industry by stripping the NYSE of the power to determine the commission rates charged by its members. Discount brokers, which focused primarily on buying and selling securities, seized the opportunity to court more seasoned investors who might not require the advice or research offered by established brokers. It was during this transitional period that Charles Schwab opened a small brokerage in San Francisco and bought a seat on the New York Stock Exchange.
1980s – The company experienced rapid growth thanks to a healthy marketing budget and innovations, such as the industry’s first 24-hour quotation service.
This fast success proved to be a double-edged sword. Charles Schwab became the largest discount broker in the U.S. by 1980, but profits were erratic, and the company was forced to rescind an initial public offering. Eventually, the company sold to BankAmerica Corporation for $55 million in stock. A mere four years later, Charles Schwab would purchase his namesake company back for $280 million.
1987 – By the time the company went public, Charles Schwab had five times as many customers as its nearest competitor, and profit margin twice as high as the industry average.
1990s – In the late ’90s, Charles Schwab moved into the top five among all U.S. brokerages, after a decade of steady growth.
2000s – The company made a number of acquisitions, including U.S. Trust, which was one of the nation’s leading wealth management firms, and most recently, the USAA’s brokerage and wealth management business.
The Race to $0
For Charles Schwab, the elimination of fees is the culmination of its founder’s vision of making investing “accessible to all”.
The company’s fees were slowly declining for decades. In late 2019, it finally took the plunge and introduced free online trading for U.S. stocks, exchange-traded funds, and options. The response was immediate and enthusiastic, with clients opening 142,000 new trading accounts in the first month alone.
Although Charles Schwab sent rivals scrambling to match its no-commission trade offer, fintech upstarts like Robinhood have offered free trading for years now. The “race to zero” reflects a broader generational shift, as millennials are simply more likely than earlier generations to expect services to be free.
The Evolution of TD Ameritrade
1975 – The origin of TD Ameritrade can be traced back to First Omaha Securities, a discount broker founded by Joe Ricketts. The company changed its name to TransTerra in 1987.
1988 – TransTerra’s subsidiary, Accutrade, was the first company to introduce touch-tone telephone trading, a major innovation at the time and one of the first early forays into automation.
Early 1990s – Ricketts’s willingness to integrate emerging technologies into the trading business helped his companies achieve impressive growth. In 1997 the company acquired K. Aufhauser & Co., the first company to run a trading website.
The Internet wasn’t a puzzle. We were crystal clear from the beginning that customers would migrate to this.
– Joe Ricketts (2000)
Late 1990s – The Ameritrade brand was solidified after the company changed its name from TransTerra to Ameritrade Holding Corporation in 1996. The newly named company completed an IPO the following year, and established its new brand Ameritrade, Inc., which amalgamated K. Aufhauser, eBroker, and other businesses into a unified entity.
2000s – Ameritrade entered the new millennium as the fifth largest online investment broker in the United States, fueled in part by marketing deals with AOL and MSN.
The modern incarnation of TD Ameritrade took shape in 2006, when TD Bank sold its TD Waterhouse USA brokerage unit to the Ameritrade Holding Corporation in a stock-and-cash deal valued at about $3.3 billion. At the time of the deal the new company ranked first in the U.S. by the number of daily trades.
2016 – TD Ameritrade acquired the discount brokerage Scottrade for about $4 billion. The deal brought 3 million client accounts and $170 billion in assets under management into the company, and quadrupled the size of its branch network.
What Comes Next?
Naturally, the announcement that these massive discount brokers plan to merge has generated a lot of speculation as to what this means for the two companies, and the broader brokerage industry as a whole.
Here are some of the consensus key predictions we’ve seen on the deal, from both media and industry publications:
- After the deal is approved, the integration process will take 12 to 18 months. The combined company’s headquarters will relocate to a new office park in Westlake, Texas.
- Charles Schwab’s average revenue per trade has dropped nearly 30% since Q1 2017, so the company will likely use scale to its advantage and monetize other products.
- The merged company will continue to adopt features from fintech upstarts, such as the option to trade in fractional shares.
- E*Trade, which was widely considered to be an acquisition target of Schwab or TD Ameritrade, may now face pressure to hunt for a deal elsewhere.
Even though these longtime rivals are now linking up, stiff competition in the financial services market is bound to keep everyone on their toes.
I think Joe Ricketts and I agree that our fierce competitiveness nearly 30 years ago is proof that market competition can be a source of miraculous innovation.
– Charles Schwab
Why It’s Time for Banks to Make Bold Late-Cycle Moves
As we enter a late-cycle economy, a staggering 60% of banks are destroying value. Here’s the steps they can take in order to succeed.
Why It’s Time for Banks to Make Bold Late-Cycle Moves
An economic downturn is approaching on the horizon. Amid low interest rates and a manufacturing slowdown, industries and investors alike are scrambling to prepare as the window of opportunity closes.
Banking is no different. After a decade of expansion, the industry is showing many signs of a late-cycle economy. On top of this, a staggering 60% of banks are destroying value. Today’s infographic from McKinsey & Company explores the steps banks can immediately take to succeed in the next economic cycle.
How is Value Created?
In the banking sector, three main factors contribute to value creation:
- The location of the bank
- The scale of its operations
- The effectiveness of its business model
Given that geographic reach is mostly out of a bank’s control, and scale takes time to build, banks must focus on their business model.
There are three universal business model levers that all banks can immediately act on to change their destiny.
1. Risk Management
Banks can protect returns in an economic downturn by managing risk. For example, new machine-learning models can predict the riskiest customers with 35 percentage points more accuracy than traditional models.
To radically reduce costs, banks can transfer non-differentiating activities to third-party “utilities”, through outsourcing, carve-outs, or partnerships. This has the potential to increase return on equity by as much as 100 basis points.
3. Revenue Growth
When customers are satisfied, they generate more value for banks—and vice versa. For instance, customers who report low satisfaction with their mortgage experience are almost seven times more likely to refinance with a different bank.
By materially improving decisive points in the customer experience, banks can increase revenue and reduce churn rates within 12-18 months.
The Four Banking Archetypes
Beyond these universal performance levers, a bank should prioritize late-cycle economic decisions based on the archetype it falls under.
- Market leaders are top-performing financial institutions in attractive markets
- Resilients are top-performing operators despite challenging market conditions
- Followers are mid-tier organizations generating returns due to favourable market conditions
- Challenged banks are poor performers in unattractive markets
Different archetypal levers are available depending on each bank’s unique circumstances.
Banks can find new revenue streams across and beyond banking, leveraging customer relationships and white-label partnerships.
Banks can create value by developing new methods, ideas, products and services. To implement this effectively, banks must set goals for the return on innovation as well as the timeframe.
- Zero-based budgeting
By justifying expenses for each new period, banks can drastically reduce costs. This involves starting from a “zero base” rather than prior years’ numbers.
Here’s how banks across the various archetypes can take action:
For example, while market leaders’ large capital base is best used for ecosystem and innovation plays, challenged banks need to radically rethink their business model or merge with similar banks.
Reinvent, Scale, or Perish
As the late-cycle economy slows even further, no banks can afford complacency. In fact, history has shown that 35% of market leaders drop to the bottom half of peers in the next cycle.
Now is the time for banks to take bold action through universal and archetypal levers—or risk being left behind.
For a more detailed breakdown of the actions that banks can take in this market environment, check out the full report by McKinsey & Company.
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