Malt Liquidity 6
Liquid lacking liquidity
Nobody’s cornering the water market any time soon
There are two theories on pricing I like to talk about: one is “theoretical pricing”, where, for example, a contradiction proof on the existence of arbitrage is used to reason that a price for an option has a “correct price”, and “practical pricing”, which is simply stating that you can’t get a fill on a price if nobody will sell it to you there. In an active market, ideally, you’d want participants with both philosophies - the theoretical price calculations involve future assumptions, which would lend itself naturally to hedgers against future price movement along with more quantitative speculators, and the practical would induce speculators to take short term risk and market makers to provide liquidity in the market. Which is why I was amused to see that the CME is launching water futures:
The Nasdaq Veles California Water Index futures can help you manage the price risk associated with the scarcity of water in the largest water market in the US.
Purportedly, these futures exist to help large California companies with heavy exposure to water prices hedge their risk against, say, wildfires, or the natural heat that comes with being a desert, but a key thing to keep in mind is that hedging in a market without speculators is impossible. Market makers make money on facilitating trades and offloading the price risk involved with taking the other side of each bet on both the bid/ask sides. If there is only one side attempting to play the game, then there’s nobody to offload the risk to, and thus there’s no point providing open market liquidity - the hedgers are better off working out an OTC product agreement with a financial institution. Speculators fuel price discovery - if multiple people believe that a price is supposed to be higher, people will bid it up, until somebody thinks that it should be lower, and starts offering it down. Thus you get the random movement that make up the lines and candles in the charts you use, and a more accurate reflection of where the market thinks the price is, so a hedger knows at approximately which price they can reduce exposure. So, hilariously enough, I can’t see how there are going to be either speculators or hedgers with this specific contract:
The January 2021 water contract that went live Monday had two trades.
The futures are financially settled, as opposed to requiring the actual physical delivery. Contracts include quarterly ones through 2022, with each representing 10 acre-feet of water, equal to roughly 3.26 million gallons.
For context, almonds, which make up $6 billion of California’s yearly agriculture receipts, require approximately 3 gallons of water per almond kernel. So, each contract is roughly the water required for 1 million almonds, and the depth of the market is currently at 2 million almonds… something tells me that there isn’t a lot of room to hedge or speculate even if the product 100x’s its trading volume (For context, front month coffee futures, which have existed for decades now, have an open interest of 143 contracts, or about 36000 bags of coffee.) Frankly, launching these futures as a marketing campaign for the next movie about whatever Michael Burry (of Big Short fame) is up to makes more sense than offering it as a tool to hedge. If you want to speculate on California water, perhaps don’t start a water park there anytime soon.
All Speculators, No Hedge
A key reason why private company valuations have been staying private much longer is due to the fact that compliance as a public company is hard! In public markets, anyone can choose to buy or sell your stock for whatever reason, even if they don’t own the stock (read: short selling). In private markets, this is much harder - there is no open market and equity purchases in funding rounds are highly restricted, so where exactly are you supposed to be able to borrow equity to sell? While this reads like sponsored content, the actual mechanics of running a 70/30 long/short venture capital hedge fund intrigue me, because I don’t fully understand how they are gaining short exposure through “venture synthetics that mimic the price performance of individual startups’ equity to do the equivalent of shorting companies’ stock…”
What I assume will happen is that this fund will try to privately source funds who wanted to go long but couldn’t get access to the funding round and try and pitch them on taking private OTC trades in some product drawn up by an investment bank, but it’s hard to see why venture capitalists, who by nature want long-shot exponential return bets, would want to start trading zero-sum bets against a hedge fund. On top of that, I am not sure what the optics of trying to fund early stage companies while also shorting others look like - on some level, you could argue that it’s a type of “hedge”, but I suspect individual series-stage company returns are too uncorrelated as a whole to have any quantitative basis for this argument, but more obviously, why would a company want to take money from you if you’re inherently 30% skeptical of the venture capital space? This is an industry, after all, that is based on pie in the sky thinking rather than rational outlooks. Further complicating the issue is that a lot of valuations are pretty much decided by what capital the company decides to take and how the firms already invested decide they want to project the image of the company. WeWork, for example, notoriously ran up to a $47 Billion valuation purely due to one backer. How is a product supposed to “pay out”? How are you supposed to be pricing the ongoing valuation of said product, when they are all singular counterparty-specific trades? While I’m sure most market aficionados feel there needs to be a “short” side of private companies as well as a “long” side to bring these valuations a bit more in line, at the end of the day, when nobody wants to hedge due to the nature of the asset class, speculators on the downside will struggle to find a way to sell down.
On that note…