Do you want to see a wild chart? Of course you do. This one is a humdinger.
As the key indicates, the blue line shows the market capitalisation of Taiwan Semiconductor Manufacturing Co in US dollars. The pink line also shows the market capitalisation of Taiwan Semiconductor Manufacturing Co in US dollars. The only difference is that the blue line is derived from TSMC’s Taiwan-listed shares, and the pink one from the company’s New York-listed shares.
You do occasionally see divergences between two listings, mostly due to one being more liquid than the other, certain types of shares not enjoying voting rights, different tax treatments, or because big pools of money cannot invest in certain markets (eg technically emerging markets like Taiwan).
A good example is the price difference between Alphabet’s GOOG and GOOGL shares. They are economically the same, but GOOG shares have no voting rights, while GOOGL holders do. As a result, they trade at subtly different prices.
This tends to be fodder for arbitrage strategies that subsist on often tiny differences between two identical or near-identical securities, which can become financially lucrative to exploit with enough leverage. For example, GOOG vs GOOGL, or the price difference between certain Treasury bonds and futures. These arbitrageurs are the police that help enforce what economists call the “law of one price” — or LOOP.
However, while TSMC might not be a household name, this is a $914bn company, making it one of the biggest stocks in the world. Or rather, it’s a $914bn company in the US. In Taiwan it’s only valued at $764bn.
LOOP violations shouldn’t be occurring — or certainly be so extreme — in stocks of this size. As Acadian’s Owen Lamont wrote last year: “This mispricing is stupid, chaotic, and embarrassing.”
Now, I don’t have an opinion about whether you should buy shares in the company, but I do have an opinion about LOOP violations: they should not be happening for the world’s 10th largest stock. If you thought that the market was getting more efficient over time, you need to explain why this premium has gone from zero to 20% in the past two years.
This is not an isolated mispricing, however. Do you want to see another wild chart? A LOOP transgression arguably so heinous that there should be an article in the Geneva Convention banning it? Here you go:
OK, so this chart may need more unpicking to explain why it’s so weird. Simplified, the chart indicates that it is much more expensive to buy the S&P 500 through futures than it is to simply buy an S&P 500 ETF or all the stocks in the index for the exact same exposure.
Because you only have to put down some money up front to buy a futures contract, they are inherently leveraged instruments. The cost of that leverage can be calculated as an interest rate (derived from the risk-free interest rate plus a spread on top). The chart shows how the implied cost of financing an investment in S&P 500 futures climbed to egregious highs last year, and remains extremely elevated at the moment.
In other words, in theory you could have captured a huge, almost risk-free spread (close to 10 per cent a year at the peak last year!) by selling S&P 500 futures and going long the underlying equities — a “basis trade” in financial jargon. And this is in supposedly the largest and most efficient financial market on the planet. If TSMC is an elephant of an anomaly, this is arguably a big blue whale of one.
Alphaville came across the aberration in this DE Shaw paper, which includes more detail on how the implied financing spread is calculated. We got in touch with Ashwin Thapar, head of multi-asset class investing at DE Shaw Investment Management, to find out what he made of it. He told us:
It’s a classic case of the limits of arbitrage being surprisingly wide, even in a market that is one of the most liquid in the world. There are examples of mispricings in many markets, but this has been exceptionally big and visible.
So what’s going on?
Well, first we need to acknowledge that LOOP is an economic theory, not a law of physics. There are all sorts of real-life frictions that can cause near-permanent glitches in markets, and there are times when it breaks down almost entirely. Seeing when that happens can be a clue to the underlying culprit.
For example, TSMC’s LOOP violation is definitely not a new phenomenon, even if it is pretty extreme right now. As you saw in our first chart, TSMC’s US shares also traded at a sharp premium in the 2021 stock market craze, before deflating in the 2022-23 bear market.
Below is a longer-run chart shows how the same thing also happened in the dotcom bubble. TSMC’s lower value at the time makes it hard to spot, but the LOOP violation was even more egregious back then. At one point in 2000, TSMC’s American depositary receipts — that’s what its US shares technically are called — valued the company at close to a 90 per cent premium to its ordinary Taiwanese shares.
This strongly implies that TSMC’s pricing anomaly is primarily driven by American stock market frenzies, and most of all retail traders.
When animal spirits are high, they simply buy TSMC’s US shares because they are the most readily available to them through US brokerage accounts. Even many professional fund managers have strict mandates that preclude them from buying TSMC’s Taiwanese shares, but they might still fancy a flutter on one of the planet’s hottest tech stocks. The price of TSMC’s ADRs therefore reflect a “convenience premium” that at times of optimism can become enormous.
Acadian’s Lamont suggests that the growth of US index funds that can buy locally-listed ADRs but not overseas stocks might also have exacerbated the phenomenon recently, but this seems unlikely. TSMC is not in any major US stock market indices, so the ebb and flow of American animal spirits seems to be the most likely cause.
In the case of the S&P 500 futures premium to the underlying cash market, that also seems to mostly reflect ravenous demand. For asset managers, US equity futures are an efficient way of getting leveraged exposure to the only game in town for the past decade.
That explains why S&P futures do tend to trade a little rich to the underlying stock market, and why the premium suddenly became a big discount in early 2020: it was another massive basis trade unwind, just like the one that struck US Treasuries. Asset managers paring back their exposure this year helps explain why the gap has narrowed from record highs to merely eye-catching levels.
Nonetheless, this still begs the question of why no one seems to be taking advantage of the seemingly huge arbitrage opportunities in TSMC’s shares and S&P 500 futures, and in the process helping narrow them?
DE Shaw’s view is that it boils down to an acute bank balance sheet shortage. In other words, the supply of financing available to arbitrageurs from banks is simply too limited at the moment. It’s like you can see the juicy unspoilt apples at the top of a tree, but the hardware shop has run out of the ladders needed to pick them.
Or as DE Shaw’s report explains.
. . . Dealers are an important source of financing for S&P 500 positions but face an important constraint: the aggregate size of the banking sector’s balance sheet is relatively fixed over shorter horizons. This is because the aggregate size of that balance sheet is primarily determined by the amount of capital held by each bank, and building or raising new capital takes time. Banks can shift capital among business lines, but there are practical restrictions on doing so. As a result, banks may not have flexibility to respond to rapid changes in demand for leverage.
This balance-sheet-shortage-meets-demand-for-leverage argument also helps explain why arbitrageurs aren’t able to take full advantage of TSMC’s share price divergence, and a host of other smaller anomalies. Equity leverage is particularly balance sheet intensive, explaining why S&P 500 basis trades are a lot harder and more expensive to implement than similar basis trades in US Treasuries.
In other words, what looks like a gross violation of LOOP is actually the rising cost of renting bank balance sheets getting baked into market prices. As DE Shaw argues:
When a market participant uses capital to sell futures and buy cash equities, they are supplying balance sheet to other market participants seeking leverage. The financing spread represents payment for this scarce capacity. So what appears at first to be a “mispricing” is instead the price of balance sheet capacity showing up in instruments with implicit leverage.
We believe this explains why levered market participants, which generally demand rather than supply balance sheet, have not yet arbitraged away this particular dislocation. If a levered player sought to profit from the elevated S&P 500 financing spread (e.g., buying the stocks in the index or a related ETF and selling the futures), it would first need to borrow from a dealer to finance the long leg. Given the supply-demand imbalance discussed above, that borrowing cost would approximate the expected gross return of the trade, precluding arbitrage profits.
So what does all it mean? Well, we mostly hoped that this was an interesting exploration of arbitrage and when it can break down in its own right.
But Alphaville does wonder what the apparently extreme tightness of bank balance sheets might mean at a sensitive time for financial markets as a whole. That will have to be an issue for a future post, however.
