A Timely Object Lesson on the Dangers of Tight Coupling in Financial Markets, and Hence the Lunacy of Fetishizing Algorithms
FTAlphaville had a fascinating piece this week in which it described a discussion at a CFTC roundtable debating the FTX proposal that is generating so much tumult in DerivativesWorld. In a nutshell, Chris Edmonds of ICE revealed that due to a “technical issue” during the market chaos of March 2020 (which I wrote about in a Journal of Applied Corporate Finance piece) a large market participant was arguably in default to the ICE clearinghouse, but ICE (after consulting with the CEO, i.e., Jeff Sprecher) did not pull the trigger and call a default. Instead, it gave some time for the incipient defaulter to resolve the issue.
This raises an issue that I have written about for going on 15 years–the “tight coupling” of the clearing mechanism, and the acute destabilizing potential thereof. Tightly coupled systems are subject to”normal accidents” (also known as systemic collapses–shitshows): in a tightly coupled system, everything must operate in a tight sequence, and the failure of one piece of the system can cause the collapse of the entire system.
If ICE had acted in a mechanical fashion, and declared a default, the default of a large member could have caused the failure of ICE clearing, which would have had serious consequences for the entire financial system, especially in its COVID-induced febrile state. But ICE had people in the loop, which loosened the coupling and prevented a “normal accident” (i.e., the failure of ICE clearing and perhaps the financial system).
I have a sneaking suspicion that the exact same thing happened with LME during the nickel cluster almost exactly two years after the ICE situation. It is evident that LME uncoupled the entire system–by shutting down trading altogether, apparently suspending some margin calls, and even tearing up trades.
Put differently, it’s a good thing that important elements of the financial system have ways of loosening the coupling when by-the-book (or by-the algorithm) operation would lead to its destruction.
The ICE event was apparently a “technical issue.” Well that’s exactly the point–failures of technology can lead to the collapse of tightly coupled systems. And these failures are ubiquitous: remember the failures of FedWire on 19 October, 1987, which caused huge problems. (Well, you’re probably not old enough to remember. That’s why you need me.)
This issue came up during the FTX roundtable precisely because FTX (and its fanboyz) tout its algorithmic, no-man-in-the-loop operation as its innovation, and its virtue. But that gets it exactly backwards: it is its greatest vulnerability, and its greatest threat to the financial markets more generally. We should be thankful ICE had adults, not algos, in charge.
As I pointed out in my post on FTX in March:
The mechanical means of addressing margin shortfalls on a real time frequency increases the tight coupling on the exchange, and is tailor made to create destabilizing positive feedback loops: prices move a lot leading to margin shortfalls in real time that trigger real time trades that accentuate the price movement. It is like seeding the market with huge numbers of stop orders, which are inherently destabilizing. Further, they can create incentives to manipulate. Anyone who can get some idea of where the stops are can “gun the stops” and trigger big price moves.
It’s particularly remarkable that FTX still is the subject of widespread adulation in light of Terra’s spiraling into the terra firma. As I said in my Luna post, it is lunatic to algorithmize positive feedback (i.e., doom) loops. (You might guess I don’t have a Luna tattoo. Not getting an FTX tattoo either!*)
FTX’s Sam Bankman-Fried is backtracking somewhat:
In the face of the agricultural industry complaints, Bankman-Fried gave ground. While maintaining his position that automated liquidations could prevent bad situations from growing worse, he said the FTX approach was better suited to “digitally settled” contracts — such as those for crypto — than to trades where physical collateral such as wheat or corn is used
Sorry, Sam, but digital settlement vs. physical settlement matters fuck all. (And “physical collateral”? Wut?) And you are deluded if you believe that “automated liquidations” generally prevent bad situations from growing worse. If you think that, you don’t get it, and are a positive threat to the financial markets.
*FTX bought the naming rights for a stadium in Miami. I say only slightly in jest that this is another indication of the dangers posed by FTX and its messianic founder. FFS, you’d think after the 2000 tech meltdown people would recognize that buying naming rights is often a great short selling signal, and a harbinger of future collapse. To say that those who forget the past are condemned to repeat it is too strong, but those who follow in the footsteps of failures that took place before their time betray an an arrogance (or an ignorance) that greatly raises the odds of repeating failure.