Arbitrage in the Age of Machine-Made Volatility

Event-driven opportunities powered by rise of machines

Oliver Dobbs, CIO founder of Credere Capital LLP
Originally published in the June 2018 issue

Investors are entering a brave new world. The machine-made crash we saw in the early part of the year was illustrative – one market misstep can create a vortex of selling. As herding in ‘smart beta’ ETFs drives increasing correlations, we could witness another snap back in a market showing signs of diminishing support. After a decade of directionality, allocators are now looking to strategies with uncorrelated sources of return – of which, some will find their diversification claims tested in potentially ultra-bearish conditions.

Against this backdrop, the scene is set for the return of relative value arbitrage strategies. The rise of the machines, combined with the decline of investment banking trading, has led to an unprecedented level of event-driven opportunities. From mispricing around new capital raises to regulatory change, shareholder buy backs, security issuance and capital restructuring, there has never been more fertile ground to unearth sources of uncorrelated alpha.

Flight of investment banks

At the heart of the reshaped landscape for arbitrage investors is the diminished role of investment banks. Higher capital charges and reduced staff numbers, precipitated by Dodd-Frank and other regulation, have created a twin headwind for the industry. In the mid-2000s, the arbitrageurs were in the ascendency with hundreds of traders scouring individual global opportunities. Now, not only have investment bank aristocracy, such as Goldman Sachs, reduced their presence, but smaller regional European banks have also scaled back operations.

This retrenchment has destroyed the culture of arbitrage within investment banking and fractured dialogue within existing market players. The US doesn’t speak to Europe and Europe doesn’t speak to Asia. And poor communication between international branches is not the only concern. Even within branches, there is significantly diminished communication between different desks.

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