How Big Can Mechanical Rebalancing Get?

Abstract

Mechanical rebalancing maps recent transaction prices into future trades, target exposures, or binding constraints. It appears in volatility targets, risk-control overlays, leverage limits, collateral haircuts, and margin schedules. Once enough capital follows such rules, trades today move the prices that set tomorrow's trades. Standard no-manipulation conditions for market impact miss this feedback. We derive a capacity test using only the rule and a market-impact estimate. The test asks whether a trader can move the rule's input and profit from the induced rebalancing. As an example, we apply the test to volatility-managed portfolios. Safe capacity is below 0.11 days of average daily volume, or 0.09% of the underlying market. At one day of volume, profitable round trips exist in 84% of stress states; at two days, in 98%. Capacity is tightest in calm markets, where measured risk is easiest to move.

Keywords: price manipulation, dynamic arbitrage, market impact, initial margin, collateral, haircuts, VaR, constraints, risk-control, volatility-managed, forced liquidation, procyclicality, volatility targeting, low risk, endogenous risk, endogenous manipulability, mechanical rebalancing, capacity test, structured products, indexed annuities, stress test, financial stability, predatory trading, systematic risk

JEL Classification: G14, G12, G28, G18, G11