Flash Crash--Part Deux

If exchanges are clearly so interconnected, why did no one see this flash crash as a potential risk? What is everyone doing with their big, fat, inflated heads in these organisations whose raison d’être, BTW, is to avoid this merde? Maybe that one comedian was right, everything worked better when martinis at lunch were tax deductible. Or do we just do not have enough cops working this beat.

We live in vulnerable times. I would really like to believe that someone is looking out for me. But I am afraid I don’t and there isn’t. I am not a cynic but this preliminary report is absurd and full of gobbledegook. This flash crash is not the most important thing that has happened lately. However, it is just too freakin' scary that they haven’t come out and admitted that this is something they overlooked—rather than some extraordinary event that could not possibly have been anticipated because after all, this is Wall Street and everything is complex and complicated.

What I really want to know is that some junior staffer wrote a memo years ago raising the issue of interconnected investment vehicles, traded across dozens of exchanges, creating the potential risk of a liquidity crunch...deja vu all over again…….and this memo was dismissed as untimely or irrelevant. At least if one little person saw this risk I would feel as if the universe still functioned properly.

Here are what I think are the primary issues raised in the report.

ETF’s

“…ETFs as a class were affected more than any other category of securities.” (in the flash crash)

Exchange traded funds (ETF) trade like stocks but function like mutual funds in that they can represent several different equities. ETF’s track the S & P 500 stocks and they often trade in large blocks. This means that when they lose value the underlying stocks are losing value. This means when traders see the S & P losing value they may want to sell in to that decline. The trader may have instructions to do this or they may want to cut their losses by selling before stocks decline further. Regardless of why, the circuit breakers need to kick in at this point in order to stop the bleeding. Those circuit breakers need to be across the board. Maybe we have found the achilles heel of demutualisation. Competitors do not like to co-operate. Believe me I know, I am the youngest of 4 girls.

Self-Help

The report discusses the affect on liquidity from the policy of ‘self-help’. For some stocks, exchanges are required to route orders to specific dominant exchanges. Which exchange is dominant will depend on the particular stock involved in the order. Declaring self-help means an exchange can re-route an order with impunity when the primary exchange does not respond to an incoming order within one second. It is these arrangements that provide some semblance of order in this new age of demutualised and electronic exchanges. Orders can go far and wide to be filled where they used to just go to the AMEX, NYSE or the PHLX.

Basically, what distinguishes stock exchanges from over-the-counter market is this kind of arrangement. Agreements regarding the primary market maker in stocks-predominately the NYSE for the S & P 500 stocks-means that the bid-ask can be managed in a reasonable, central way in order to avoid spreads that are unreasonable, unknown or worse, vastly disparate between exchanges.

SO, when the NYSE goes slow because of a sudden drop in prices, response time to incoming orders will be longer than one second. If an order is required by agreement to go to the NYSE first, self-help releases incoming orders from that obligation. The order is then re-routed to another exchange. This contributes to less liquidity on the NYSE for that period of time. This may be what happened on May 6^th.

Futures market

”…there were many more sell orders than there were buy orders” An actual quote from a report issued by two regulatory agencies.

The Chicago Mercantile Exchange (CME) employs something called stop logic functionality. This facility pauses trading in certain futures when the last transaction price would trigger stop loss orders which, if executed, would result in precipitous declines in prices. Stop loss orders sit on the books and are used by investors big and small in order to indicate the bottom price where a stock must be sold in order to prevent further loss for the investor. It is not particularly sophisticated but functions as a way to stop the loss of value.

Simply put, you buy a stock or future at $45 per share and hold it in your portfolio. You have the broker enter a stop-loss order at $20 per share. God forbid the stock drops that low but when it does you sell your shares at $20 rather than at $10 or pennies per share.

Stub quotes

I don’t know a lot about this but will educate myself and return to the topic but I suspect this is a non-issue. These quotes are bottom quotes that are not anticipated to reflect the actual market. They came into play because the price drops were so fast.

The real issue is that in the ‘olden days’ NYSE specialists existed to provide liquidity and order. That was their professional obligation and they were seriously good at it. When orders can be re-routed all over the electronic universe who is managing the bid ask spread so that investors have consistency, transparency and predictability??? There has got to be someone in charge-an exchange that is the facilitator of last resort. Why are we still learning this lesson?

I increasingly feel as if the inmates have been running the asylum. Here is a quote from the report followed by my translation:

“CFTC staff is considering a proposed rulemaking with respect to exchange co-location and proximity hosting services. The purpose of the proposed rule would be to ensure that all otherwise qualified and eligible market participants that seek co-location or proximity hosting services offered by future exchanges have equal access to such services without barriers that exclude access, or that bar otherwise qualified third-party vendors from providing co-location and/or proximity hosting services. Another purpose of the proposal would be to ensure that futures exchanges that offer co-location or proximity hosting services disclose publicly the latencies for each available connectivity option, so that participants can make informed decisions.

CFTC Staff will also be considering possible rules to enhance the CFTC’s surveillance capabilities. These measures include automation of the statement of reporting traders in the larger trader reporting system and obtaining account ownership and control information in the exchange trade registers”

June’s translation:

“Uh, fellas, the good times are ova. We can no longer make country club membership exclusive. Things are gonna be transparent. Playing in this game was so much more fun when it was limited to a few who reap all the fees and set all the rules. Dammit! Now we gotta disclose things and allow everyone to play.

Also guys, no more secret trading through a numbered account, we hafta know who ya are and what ya did and we’re gonna get the Geeks to write a program to help us do it.”

You get the idea. I could do this for all 151 pages of the report. They are proposing lots of joint studies one which will “…examine linkages between correlated assets in the equities (single stocks, mutual funds, and ETFs), options and futures markets.” They don’t know this stuff already? I mean with all the B’schools in NYC and D.C., you’re telling me some undergraduate hasn’t done a project or paper on this because that is the level we are talking about--baby stuff guys. Knowing how all your fancy products function together is your J-O-B.

This is how the report should have read:

“Dear American Investor and legislator,

We have been having so much fun making money over the last 20 years that we couldn’t really have cared less to understand how things work or what kind of markets we were creating. Sure we had a few scares over the years but we survived, passed a few rules, shifted blame. We have been exceedingly occupied with fighting against disruptive interference by busybody regulation year after year all with the sole purpose of bringing you the wealth that you now enjoy. We just learned last week how to even spell transparency.

Either way, we’ve been busy and now we are now ready to focus on this problem. But remember it is very, very complex and complicated. It will take years and many, many meetings in Boca or at the Greenbrier to make any real progress.

Please be patient and continue to love Wall Street because it has made this country what we are today.

(Air kiss)

Your friends in high places,

The Securities Regulating Elite”

Full stop

www.sec.gov

Flash Crash preliminary report

The Commodities Futures Trading Commission (CFTC) and the Securities Exchange Commission (SEC) issued a preliminary report on the flash crash of May 6^th. Fundamentally, there is no conclusion in the report. It does however; deduce some suspects for the temporary but serious liquidity shortage.

The report states that Exchange-traded funds (ETFs), individual equities, short selling, and S & P futures were all factors in the flash crash. Also, the report suggested that the NYSE Euronext circuit breaker which kicked in to slow down trading may have accelerated the exodus of trades to other exchanges contributing to the loss of liquidity.

It is extraordinary to think that determining the cause of this crash is so elusive. Why is it that every time we demand answers, Wall Street explains to us how ‘complex’ and complicated what they do is? How can that be?

Stocks are bets that companies will do well and hence prices will go up. Derivatives are bets that something-a company, a commodity, a mortgage, will go up, down (fail) or maybe go sideways. That is not the hard part. The difficult part for the CFTC and SEC must be how quickly these trades can go from exchange to exchange leaving disaster in their wake. And if that is it, why did nobody anticipated this??

Either they really don’t know what happened on May 6th, which is so scary, or they know and need time to present matters in a palatable way given the political climate. (e.g. Financial Reform moving forward)

Taking everything at face value, the report states that it will take time for staffers to go through the voluminous trades and data from that day. Until they can analyse that information no one will know for sure what caused the precipitous drop in prices. Hopefully, pressure will remain on these regulatory agencies until they determine and publish a report explaining the cause. If the problem is technology getting ahead of the exchanges or getting ahead of regulation then some time needs to expended rectifying that shortfall.

Von Abo et al

It appears that more interested parties are attaching Zimbabwe owned properties in South Africa. Recently, a German development bank, KFW Bankengruppe attached 6 properties located in SA and owned by the Zim government. The attachment is intended to satisfy a debt owed the bank by the government of Zimbabwe.

Apparently, the government of Zim borrowed the money through the entity, Zimbabwe Iron and Steel Co. Ltd in 1998. The loan amount, 40 million Euros, was to be paid in instalments. The government defaulted in 2002 after making 4 payments.

The bank made several attempts to collect. It even hired an arbitrator to assist in obtaining payment of the debt. Success was elusive so the bank sought redress in the courts.

Some of the properties are the same ones sought after in satisfaction of the Von Abo v. Govt of the Republic of South Africa, et al 3106/07 decided 5/2/2010 case. The Von Abo case in SA was merely about registering the SADC tribunal judgment against the government of Zimbabwe in favour of white farmers who lost their land without compensation. The SADC tribunal found Zimbabwe’s land reform programme discriminatory based on race.

The properties will be auctioned by the Sheriff in late July 2010. The German bank and the plaintiffs from the SADC tribunal judgement intend to share in the proceeds proportionately.

No matter whose side you are on this is a fascinating turn of events.
Lawyers intend to get paid-even when they work for banks.
Debts to banks do not get forgiven in a recession.
Gotta pay the piper eventually.

see www.zimeye.org

900+ point plunge=domestic terrorism?

The Wall Street Journal online edition had an article recently describing the meeting between all the major exchanges on Monday regarding new trading rules for circuit-breaker or stock-halt systems. The articles discussed the proposals for making arrangements between exchanges-that are competitors let's not forget-when stocks trade in ways that make us too nervous to breathe.

Under the article in the comment section was a comment that claimed that the banks created the freefall in stock prices intentionally in order to influence the vote on the Brown /Kaufman amendment to the financial reform bill. The Brown/Kaufman amendment would limit the size of banks. If passed, it would force current ‘oversized’ banks, with assets of over $100 billion, to sell off branches to smaller banks. The purpose of the amendment is to prevent banks from not only getting too big to fail but also to prevent the abusive and predatory behaviour of large banks. Of course, this was not a popular amendment among banks.

The vote on the amendment, held suddenly and late in the evening of May 6^th, was 33-61 against. The amendment failed to be adopted.

I liked the idea that the banks created the plunge to send a message to Congress. It is very mafia-finding a horse head in your bed-kinda thing. We cannot really know how the plunge was precipitated until everyone finishes their CYA manoeuvres.

Tuesday May 11, some stock exchange heads along with SEC Chairperson Shapiro will testify before the House Financial Services Capital Markets Subcommittee. They will talk about what happened and the agreement the big exchanges have come up with regarding circuit-breakers stopping plunges in the future. Some of this may result in some interesting trading rules changes and we can delve in to those as they are revealed. Maybe we can hear a clear explanation of how it all happened in the first place. Fat fingers or Fat Tony??

Also, the financial reform bill with all of its amendments is predicted to be passed by June. Once all the wrangling is over it will be fascinating to read what our fearless representatives have come up with to protect us from….whatever happened to us in the past few years.

http://www.opencongress.org/articles/view/1865-A-Failed-Vote-on-Breaking-up-Banks

Getting over Goldman

To my mind, there is nothing of interest to add to all of the news regarding Goldman this week. Everyone has obviously hunkered down and are working the press to their advantage. I have included some interesting links here. I like these since they try to get at the heart of what the case is about-right or wrong.

http://truthiscontagious.com/2010/05/01/the-great-american-mortgage-casino-%E2%80%93-how-the-goldman-case-is-about-the-broken-down-system-that-allowed-massive-gambling-in-america%E2%80%99s-housing-market

http://blogs.wsj.com/deals/2010/04/23/what-is-the-goldman-case-really-about/tab/article/

http://www.secactions.com/?p=2172

I am very bored with this domestic story. The Senators care about re-election and Goldman wants to preserve its bottom line by explaining that the American public just cannot wrap their collective mind around what a market-maker does. It is all so simple. I only wish we were all as smart as those Goldman guys.

Sadly, this system is still broke(n) and there is no regulation that can fix it. We need to learn from this whole financial crisis thing…really learn something. We need to continue to have ‘populist’ outrage and get some changes made. And we need to change ourselves too. Goldman is not the baddie that made so many people borrow too much and believe that trees grow to the sky. Greed is bad. Regulation cannot correct that. It might however, be able to prevent firms from benefiting from our desire for more, more, more.

Rwanda has an election this year. Angola is meant to open a bourse before 2011. Tanzania has naturalised over 150,000 Burundi refugees. All equally as interesting as Goldman if not more so and I turn my focus to Africa—that is, unless something really cool happens in the case then I am all about domestic securities regulation and enforcement!