Technological and institutional panic may be eroding return on investment

There is a link missing in the rehashing by commentators and analysts of the accounting, governance, and regulatory issues that give rise to corporate scandals such as Steinhoff and Resilient. It’s the
role played by investors and technology in creating financial crises.

There is still no clarity as to what precisely the problems at Steinhoff were – or may still be.

The markets reacted in knee-jerk fashion to hints and rumours on 6 December 2018. In their panic, by bailing out, investors themselves destroyed most of the value Steinhoff could still be delivering.

At ZAR X, we believe that there is a clue to risk management for all of us in the fact that, within 24 hours, the shares had rebounded significantly. Reason had reasserted itself. Investors realised that the herd mentality had unwittingly been self-fulfilling in causing an over-sold market, that there was more froth than substance to the ‘scandal’, or that the organisation was large enough, globally, to keep functioning rather than collapsing.

This reaffirms that reason and independent conviction are the best possible risk mitigation strategy. What the Steinhoff situation proved is not just that company directors and their accountants and auditors need to be more alert and pro-active. Players along the full length of the value chain need to take a strong governance position in order to prevent value destruction. We all need to take responsibility in our respective ways for reducing market risk. If we insist on handing it off to others, we actually become risk factors ourselves.

Notice the much steadier response by the financial markets to the Capitec ‘loan shark’ puffery by US short seller, Viceroy, as an example of the market sensibly, and ethically taking the time to assess the information it was receiving before reacting. Capitec shares dipped briefly but recovered within hours.

Also of concern is the role technology plays in initiating and spreading panic in the markets, thereby constituting a risk to stability and growth.

Algorithms automatically trigger selling of shares at certain price levels, correlations or trading patterns. These sells in turn create new reference points, which trigger further sells, thus becoming a self-fulfilling exercise. By the time humans have understood the reasons for an initial dip, tremendous damage will
have been done.

During Monday 5 February 2018, the Dow Jones sank by 4.6%. In the afternoon, there was a 15-minute period when prices fell extraordinarily rapidly. Commentators believe that the drop in the morning was caused by human decision-making that then triggered computerised trading to go into free-fall. The US Secretary of the Treasury, Steven Mnuchin, stated that computerised trading ‘definitely had an impact’ on share price drops. One has to ask whether the trading in Steinhoff should have been halted or even suspended.

Computer trading also creates risk by inhibiting financial access. Only market makers with deep enough pockets can afford the most sophisticated systems with which to do high frequency trading.

While high frequency trading is touted as the best means to reduce disparities between buying and selling prices, by excluding smaller brokers and investors it shrinks distribution options and, in the process, liquidity.

It also reduces portfolio diversification. Investors have too high a stake in too few types of shares. As a result, when a rumour about a company like Steinhoff starts, the pressure to get out of one’s position can overwhelm logic. The risk high frequency trading introduces is subtle but significant and multi-layered.

All players accept that risk is inherent in the financial markets. It’s fundamental to the creation of returns. But, our view of it remains too conventional.

We’re not looking outside of regulation and accounting practices at behavioural issues, such as greed and self-interest, and we’re ignoring deeply entrenched assumptions about the role the financial markets play in society. We see the financial markets as something separate from the rest of society and, therefore, exempt from moral restraints. This may be the biggest risk factor of all.

We fall back on rules imposed by regulation. But, rules are continuously circumvented. Also, it’s impossible to anticipate all the permutations of an evolving business environment in time to pre-empt every type of silly or criminal behaviour.

Everyone in the financial markets value chain should be working within a principles-based regime in which integrity and expertise are the basis for decisions. This is already the case in other markets worldwide, with the British environment showing the way.

Within a principles-based approach, for example, a stock exchange that sees shares going into free-fall should simply bar trading in those shares until reason reasserts itself. If the market still wants to sell when it’s had time to examine the facts, then we can be fairly certain that sense has prevailed, and market forces are operating properly. As we saw with Capitec, it doesn’t take long for sentiment to drop from feverish, fear-driven levels to logical ones.

The buck has to stop somewhere and, when institutional investors in particular are being driven to sell on the basis of flimsy or distorted information or simply out of fear of what other investors will do in response to incoming data, then it’s the stock exchange that has the means to restore order.

Every exchange is a regulator in its own right and its responsibilities go beyond the simple ones of listing, broker, and investor requirements.

That said, everyone else in the value chain should be thinking all the time about the risk their own actions pose to the markets – and to their own returns. We also all need to rethink the value computer trading offers in relation to the risk it creates.