Streetwise Professor

Europe is thrashing about like a gaffed fish on a boat deck.  The proof?  In a sure sign of desperation, and an effective confession of impotence, Germany has instituted a broad ban on short selling:

Germany will temporarily ban naked short selling and naked credit-default swaps of euro-area government bonds at midnight after politicians blamed the practice for exacerbating the European debt crisis.

The ban will also apply to naked short selling in shares of 10 banks and insurers that will last until March 31, 2011, German financial regulator BaFin said today in an e-mailed statement. The step was needed because of “exceptional volatility” in euro-area bonds, the regulator said.

The panic is particularly evident in the hurried nature of the ban–it goes into effect almost immediately.  (In fact, it went into effect a few minutes before I posted this.)

And it don’t stop there, folks.  Germany’s ruling coalition is also calling for implementation of a transaction tax.

Germany.  Shooting the messenger with an MG-42.  Fat lot of good it will do them.

Indeed, if anything, these measures will make things worse.  This is true in part for signaling reasons.  Markets can smell desperation, and react to it.  This is a desperate move that signals utter policy bankruptcy, and an unwillingness to grapple with the underlying problems.  If people want to short, it is because they think things are overvalued.  And nothing shouts overvalued like financially strapped governments with deep structural budgetary problems spending time and effort tilting at speculative windmills, rather than tackling these underlying problems.  And if the Germans thought things were under control, why take such measures?  The immediate inference is that the Germans think things must be pretty bad.

These measures will also make things worse because they will impair liquidity, and shift selling pressure into other markets.  Some “naked short” CDS are in fact hedges.  Dirty hedges, but hedges nonetheless: market participants may short a more liquid credit in order to hedge a position in a related, but illiquid credit (perhaps one for which no CDS is traded at all).  But if they’re doing this, it’s because they want to reduce their exposure.  The ban doesn’t make that desire go away.  So, they’re likely to respond by selling off some of the more illiquid cash positions.  Shorting liquid bank stocks can also be a dirty hedge for exposures in less-liquid bank stocks or debt.  Again, the ban will redirect some selling into less liquid instruments.

The transactions tax, if implemented, could be especially pernicious in these conditions.  It will reduce liquidity.  It will also impede the reallocation of risks to those willing to pay the most for them.  This is hardly the way to bolster the financial sector.

All of the measures Europe has adopted, starting with the bailout, to the not-so-sterilized intervention that has cratered the ECB’s credibility, to the short sale ban, fail to come to grips with the underlying solvency problem.  Indeed, they all signal a basic refusal to deal with that–especially the last.

In the initial EUphoria following the announcement of the $1 trillion initiative, I thought that the key indicator of its ultimate success would be the Euro.  And after an initial spike, it has been down.  Down hard.

It is now trading at a 1.21 handle.  It is down 2 cents since about 11:30 CT today (CME futures).  I haven’t been able to confirm the time that the BaFin announcement was released, but I received an email with a story confirming the ban at 1:30 today.  So I suspect that most of the hard selloff in the Euro was a direct response to the announcement.  (Hey, if you can’t short the governments or the banks, might as well short the currency!)

That’s great for those of us planning a European vacation (volcanoes permitting), but it is a very bad omen for Europe.

It ain’t so great for the rest of the world either.  The European chaos, combined with China’s attempts to de-fizz is weighing on commodity prices: oil is down (below $70/bbl on the WTI) and copper is down too, below $3.00/lb.  This does not bode well for growth in the near term.

Look out below.  Especially in the Eurozone.  And no, a short selling ban doesn’t make much of a parachute.  An anvil is more like it.

My appearance on Fox Business was going along swimmingly, when it was terminated abruptly to cover Obama’s statement about the Gulf oil spill.  Talk about your warped priorities.

I’ll post a link if one goes up.

S&P has put LCH.Clearnet on a credit watch for a potential downgrade.  The rating agency did so in response to NYSE Euronext’s decision to set up its own clearing operations, rather than use LCH’s.

This is a very useful reminder that CCPs do not make counterparty risk disappear, as certain people are wont to assert.  (You know who they are.)

But there is another important lesson here.  Nobody knows exactly how the market is going to evolve after the imposition of clearing mandates.  In particular, the structure that will evolve for the clearing business is subject to huge uncertainty.  As the NYSE-Euronext decision illustrates, and as the ICE decision to clear for itself before that,  and as did the decision of the SWX to clear for itself before that, clearing structure is a strategic choice for exchanges.  I wrote about this aspect of clearing ad nauseum before the financial crisis.  At the same time, there are strong scope economies to clearing across multiple instruments.   The push of strategic incentives to vertically integrate and the pull of incentives to exploit scope economies by using multi-exchange platforms like LCH make it very difficult to predict what the configuration of the market will look like.  This, in turn, makes it virtually impossible to understand what the systemic risks will be, and what measures will be necessary to mitigate the systemic risks inherent in clearing.

These systemic risks will depend on the topology of the clearing networks, and this topology will be determined by a complex interaction of incentives to integrate and dis-integrate.  Moreover, the topology is unlikely to be static, as the factors driving the costs/benefits of integration and disintegration will not be static either.  Thus, the interconnections in the system will be quite fluid, and as the financial crisis and the flash crash demonstrate, these interconnections can be the sources of systemic risk, if not understood and managed properly.  Force feeding clearing will only heighten the salience of these interconnections.  It will be a challenge to understand, let alone to manage, this system as would be necessary to realize the happy predictions of those who look on clearing as the cure.

Are the regulators ready for this?  Do the legislators who are enamored with clearing understand this?

There is now pretty convincing reporting that a single trader on the EMini indeed started last Thursday’s market bungee jump.  An Overland, KS fund manager submitted 75,000 EMini orders during the key time period. The firm in question, Waddell & Reed, has issued a statement.  Here’s the key bit:

On May 6, as on many trading days, Waddell & Reed executed several trading strategies, including index futures contracts, as part of the normal operation of our flexible portfolio funds. Such trades often are executed in response to market activity, and are undertaken to protect fund investors from downside risk. We use futures trading as part of this strategy, broadly known as hedging.

Portfolio insurance–the replication of puts on portfolios using dynamic trading strategies–is a strategy intended to protect fund investors from downside risk.  It is a strategy that is executed in response to market activity; prices move, leading the portfolio insurer to trade to keep the delta match; the insurer chases the market (which is how, in effect, it pays the option premium).  The W&R statement could therefore be describing a portfolio insurance strategy, or something quite similar.  (Placing stops at different price points effectively does the same thing.)

Done in an illiquid market, especially in the size indicated (with one firm trading more in less than an hour than the EMini market usually does in an entire hour), this could start the feedback loop that exacerbates market movements.

All of this is completely in line with my earlier conjectures: (1) big trades in a market index were likely to be the precipitating factor, and (2) positive feedback trading strategies were involved.

Again, though, the fascinating–and comforting thing–about this episode is that whereas in earlier episodes (e.g., ’87, ’29), the market crashed and then went “splat”, this time it bungeed back almost immediately.  That’s what sets this episode apart, and I hope that regulators and exchanges make sure they understand why that happened so it can recur in the future if need be, and so they don’t do something stupid that would not materially reduce the possibility of the market from going non-linear but which would prevent rapid self-correction like that which occurred on the 6th.

In their never ending search for bad ideas to embrace, regulators are contemplating imposing participation obligations on market makers:

Proprietary trading firms are concerned that last week’s market tumult could see regulators seek to attach more strings to their trading activity, requiring them to buy and sell shares even when they’d rather not.

Securities and Exchange Commission Chairman Mary Schapiro said Tuesday that regulators are weighing obligations that should apply to such firms, after some “professional liquidity providers” stopped trading amid last Thursday’s heated volatility that saw U.S. markets quickly plunge and then rebound.

The command-and-control mindset is running amok in Washington.

How about some basic economics, OK?  Putting aside how you would even define and enforce such obligations, imposing an obligation that firms make a market when they would rather not voluntarily, or to make a market in a size that is larger than they would choose voluntarily, imposes costs on said firms.  This reduces return on capital.  Since capital must earn a normal return, the mandate-caused reduction in return will lead to an exit of some capital from market making.  This will reduce liquidity in periods in which the constraint to make markets is not binding.  Spreads will be higher, and depth lower, during these times.  This will generate higher profits then that will offset the losses market makers must bear when the constraint binds.  (There could be a perverse dynamic here too.  Less liquidity in normal times increases the likelihood (all else equal) of a big price move that may trigger the constraint.)

One can also foresee the potential of a return to the specialist bargain of the old days.  Specialists had an affirmative obligation to make markets, even when it is unprofitable.  They were compensated in the form of entry barriers and information advantages that allowed them to earn rents in times when the obligation constraint was not binding.  But the effect of this was quite similar to what I just sketched out: trading costs are lower when the constraint binds, trading costs are higher when it doesn’t.

In three words: No Free Lunch.

Futures markets almost never impose such obligations.  There are some exceptions, in which there are designated market maker programs, usually implemented to promote trading in new products.

In essence, market making obligations alter the time pattern of liquidity.  Liquidity is higher in some periods, lower in others.  Overall, liquidity is lower, because the constraint necessarily reduces the capital devoted to making markets.

Does Mary Shapiro, or anybody else, know what the “right” pattern of liquidity supply should be?  Do they have any idea of the effects of such a constraint.  Almost certainly not.

Could competition between exchanges ensure the provision of the right amount/pattern?  There’s room for skepticism.  Assume exchange E imposes the constraint, but exchanges X,Y, and Z don’t.  During normal times X etc. will get more business because market makers on those exchanges incur lower costs and don’t have to charge the premium that E’s market makers do to cover the costs of making markets during volatile times.  During the volatile times, E’s market makers will attract business–just when they don’t really want it.  So exchanges could free ride on any other exchange that imposes the obligation.

Is there an externality or other “market failure” that could justify imposing the obligation on all market makers and exchanges?  The Greenwald-Stein story suggests that yes, that is a possibility.  But the mechanism to deal with that is to switch from continuous trading to a call auction market.  With multiple exchanges, that switch must be coordinated across exchanges.  The lack of such coordination exacerbated problems on 6 May.  Before imposing additional obligations that will harm market quality during normal periods, it would be better to improve intermarket coordination.

Moreover, as the CME experience shows, circuit breakers that focus on stop orders is a reasonable, relatively light-touch functionality that can mitigate some of the most serious problems.  Why not try that before imposing difficult to define, hard to enforce, and costly obligations on market makers?

Sarah Lynch has a VERY interesting story in today’s WSJ about how CFTC economists could find little evidence that speculation distorted commodity prices, and energy prices in particular.  (I’m quoted towards the end.)

Not that I’m surprised.  Hard to find stuff that don’t exist.

An Aug. 21, 2009 memo written by two agency economists and addressed to Treasury Secretary Timothy Geithner points to an internal CFTC debate over position limits. A CFTC spokesman said Mr. Gensler hadn’t read the memo or sent it to Mr. Geithner.

The memo analyzes the impact a lack of position limits may have had on energy markets after Congress voted in 2000 to replace them with a new and less stringent accountability level regime. Accountability levels are non-binding thresholds that merely trigger additional oversight if exceeded.

According to the memo, New York Mercantile Exchange data from between 2000 and 2009 show that the switch to the new accountability regime in 2001 didn’t change energy-price volatility.

“In our analysis of the impact of position limits, we find little evidence to suggest that changes from a position limit regime to an accountability regime, or changes in the levels of position limits impact price volatility in either energy or agricultural markets,” the CFTC memo states. “Our results are consistent with those found in the existing literature on position limits.”

Again.  No surprise.  In 2004 I did a very extensive study on the effect of the move to an accountability regime on volatility in nat gas at the behest of the Industrial Energy Consumers of America.  I found nothing.  IECA was not pleased.

It is revealing that Gensler allegedly never saw the memo.  Nor did Geithner, to whom it was addressed.  But since Gensler assuredly had his mind made up already (and/or had marching orders from Congress), it probably made no difference.

Here’s the most interesting part of the article:

Other internal emails drafted in August 2009 by the agency’s now Acting Chief Economist James Moser reveal he was concerned about how to craft a position limit rule.

Mr. Moser was at the time the agency’s deputy chief economist and sent an email to CFTC Commissioner Jill Sommers’ staff member expressing his views.

“I think of a position limit as a tool,” he wrote. “That tool needs to be calibrated to the problem it hopes to solve. Because we have no statistical evidence of a problem, we are not able to calibrate the tool to fix the problem.”

I feel your pain, Jim.  What you said is spot on.  But your big mistake is your touching belief that policy should be made on the basis of evidence.  How quaint.  (By the way, you can tell everybody you don’t know me.  I’ll understand.)

Lynch’s story also includes a link to a CFTC report on the effects of speculation and commodity funds on prices.  The study is an extension of earlier CFTC work that had drawn the ire of Commissioner Chilton.  The extended report, which as Lynch says expressed the no-speculative-effect view “more forcefully” never saw the light of day until it was unearthed via a FOIA request.  Go figure.

In its position limit NOPR, CFTC disclaims any need to show that speculation actually has caused unwarranted fluctuations in prices before imposing the limits.  It has to say that, because it’s pretty clear that its economists can’t do so.  But this isn’t about economics.  Its about belief, and politics.  Gary Gensler and Bart Chilton have a fixed belief about speculation and a political agenda to implement.  They’re not about to let something as irrelevant as evidence get in their way.  Hopefully the other commissioners feel differently.

As I am quoted saying in the article, CME and FIA have argued that as a legal matter CFTC must make a finding of speculative impact before imposing limits.  I don’t know if they’re right as a matter of law, but I’m sure we’ll find out soon enough.  And if a judge decides it must, GiGi is going to be in a very, very awkward position.

And doesn’t this story make you feel warm all over at the prospect of handing over vast new powers to the CFTC, especially a Gensler led CFTC?  A cavalier approach about economic logic and evidence about speculation in energy markets is bad enough.  Extending such an approach to oversight of trading and clearing of the vast OTC markets would be infinitely more dangerous.

CME Group Chairman Terry Duffy’s testimony before a subcommittee of the House Financial Services Committee is quite informative and fascinating.  Of course he is defending his firm and talking his book, but he makes a very persuasive case on many issues.  What he says does not demonstrate that the May 6 market boomerang did not begin at the CME (sorry about the double negative), but he does make it pretty plain that precautions built into the CME’s Globex system worked to arrest the decline, and that the rebound probably began at CME as a result.

The Duffy testimony provides concrete evidence that stop orders were accelerating the price decline.  An EMini trade at 1062 triggered a stop for a relatively modest 150 contracts.  Execution of this order led the market down to 1058.25: that big move in response to a small order indicates how illiquid the market was (i.e., how low the depth was).  (I will dig up an article by Hasbrouck that estimates depth coefficients using Bayesian methods to see how this compares to the usual market depth.)  This triggered another 150 car stop order which led the market down to 1056.

At this point Globex’s Stop Price Logic kicked in:

Stop Logic

The Globex trading platform is programmed to prevent the continuing execution of cascading stop orders when it detects certain conditions. The Match Engine monitors if the triggering of a stop order or series of stop orders will result in matched prices that exceed the contract’s No Bust Range from the price level that matching limit orders finished matching and caused the triggering of a stop order(s) . The contract is then placed in a reserved state, during which orders may be entered, modified or cancelled but not matched.

The market went into a stop state for 5 seconds.  The decline stopped, and the rebound began as value buyers–almost certainly including some dreaded HFTs–began to buy.

Duffy’s account confirms the main elements of the scenario I sketched out a couple of days back.  The market was relatively illiquid; something triggered a relatively large price move; that triggered stops and a further decline of liquidity, which accelerated the market decline; then value buyers moved in.   Duffy’s testimony also illustrates the essential element in keeping things from going completely non-linear: stopping stop orders.  I repeat: stopping stop orders.

Things were uglier on the cash equity markets.  The price declines in individual stocks, including heavily traded broad market gauges such as the SPY were more severe than on the index futures.  As is well known, some stocks traded at a penny before bungeeing back to reasonable levels.

This reflects, in part, the evolution in the market architecture in the years following the SEC’s approval of Regulation NMS.  As I wrote in this piece in Regulation Magazine, the SEC had a choice between two alternate ways of creating a national market system: a mandated central limit order book (“CLOB”) or what I referred to as an information-and-linkages approach.  The latter means that the mandated dissemination of quote information to permit direction of orders to the best-priced markets, and the requirement that different execution venues redirect orders to other venues displaying better prices.  In Reg NMS, the SEC choose information-and-linkages.

That approach is defensible, and can work well in normal market settings.  The Boomerang illustrates, however, that this architecture has an Achilles heel during periods of extreme stress and low liquidity.  The linkages don’t work properly, the markets fragment, and prices in some venues can diverge wildly from those in others.  During the crash, several venues declared “self-help” which meant that they would not direct quotes to other markets that were not responding within a second.  In other words, every man (market) for himself, and to hell with the women and children.  The linkages broke down.

As a result of NMS, the NYSE has gone from doing about 80+ percent of listed volume to less than 30.  That’s not a big deal in normal times, as information-and-linkages works OK then.  In the stressed time, though, it was a big deal.  Especially since one of the NYSE’s circuit breakers, its Liquidity Replacement Points stopped continuous trading on that market, but didn’t affect others.  So orders ricocheted off the NYSE, bypassing whatever liquidity was there, and overwhelmed liquidity on other markets.

I should note that even centralized markets can fragment.  Back when the pits were big (e.g., T-bonds, T-notes), when trading was active there would be different prices at different points in the pit.  This happened in the ’87 Crash too.  The firm I worked for was doing some simple index arb trades during that period.  Looking at our wondrous Telerate screens, it looked like there were huge arb opportunities.  (There weren’t, because the prices coming from the NYSE were absurdly stale.)  We called down to the floor to see where we could execute the futures leg.  The guy on our floor desk said: “Somebody’s bidding P1 over here, somebody else is bidding P2 over there, and there’s a guy offering P3.  So, I don’t know what the f*cking price is.”  [I don’t remember the exact numbers, except that they were index points apart.  I do remember that last sentence.  Go figure.]  But that can’t happen in a CLOB type electronic system.  (And Globex is effectively a CLOB.)

The Boomerang almost certainly means that the SEC will have to revisit the information-and-linkages approach.  It will have to coordinate the adoption of rules and technical interfaces that prevent the fragmentation, or it will have to consider jettisoning the concept altogether.  At a minimum, the rethink on the information-and-linkages approach will require coordinated circuit breakers.

And the CME experience suggests that the most essential thing to do is to implement a coordinated stop logic analogous to the CME’s.   It is imperative to derail that positive feedback mechanism.  The whole self-help thing (i.e., the every-man-for-himself-delinkage of the information-and-linkage system) also deserves close scrutiny.

The hyperventilating about HFT continues.  Duffy defends it, and defends it well.  Again, HFT is not a homogeneous thing, so it is essential that any evaluation of it take into account the diversity of these strategies.

Also, it bears repeating that the “where did it start?” question is secondary to “why did it spread the way it did?”  and “why were some markets impacted more severely than others?” questions.  And as for those questions, I think the SEC will have a lot of ‘splainin’ to do, Lucy.

No, this isn’t another post about Somali pirates.  It is another post about criminal investigations of financial institutions, relating to their involvement in synthetic CDO on MBS transactions.  This time it is Morgan Stanley in the cross hairs.

The WSJ article is maddeningly short on details.  For instance, it states that there was an option feature in the deals (“a structure that could increase the magnitude of the bullish investors’ exposures to the underlying mortgage bonds”) but it doesn’t say who had the option–the buyer or the seller.  Not that it matters if the feature was in the contract and the parties both knew about it.

These are treacherous waters for several reasons.  First, the WSJ article suggests that the crime is being short and making money on a deal.  Look, with a synthetic CDO there’s always a short.  Even the accusations against Goldman look sketchy; the allegations here look even sketchier because there’s no indication of a Paulson lurking in the background.  And even if MS was short this deal, the article suggests that it was actually net long mortgages.  Is it somehow a crime to reduce length by shorting?  How would that be different than selling some of the mortgage positions it already held?  And even if the short was a speculation not a bet–should that even matter?  But given the superheated atmosphere in Washington, the routine demonization of shorts in general, and the special demonization of those who shorted CDO on MBS (even if on net you were long), you can’t rule out the possibility that shorting itself is the crime.

Does this mean that markets should only have buyers?  Just asking.

Second, as I wrote in my piece on the Goldman criminal investigation, a criminal case against a big financial firm could cause it to unravel, with knock on effects hitting other institutions it trades with, and other entities that buy its paper.  In brief, a criminal case could cause a systemic event.

This is all the more true inasmuch as it appears that the inquiries regarding CDOs are widespread, and touching virtually ever major financial institution.  This could become the mother of all systemic crises.  Given the serious potential fallout, it better damn well be that shorting itself is not the crime.

Michael Lewis makes this trenchant observation, in a mock memo to Lloyd Blankstein:

This time, please, do not wait five months to internalize my new action items. They are:

No. 1: Implicate the rest of Wall Street, as quickly as possible.

It’s always unnatural to hear the name of Goldman Sachs in the same sentence as Deutsche Bank, much less Merrill Lynch. We must put aside our revulsion. The American people might enjoy seeing one firm being driven out of business by a criminal investigation. They’re less likely to allow for the destruction of every big Wall Street firm. They just forked over trillions to keep them afloat.

If being short is the crime, certainly all Wall Street can be implicated.  Or maybe the name given to the deals (“The Dead President” deals, since they were named Buchanan and Jackson*) is the sin.  Sounds bad, must be bad.  (This actually seems like something out of Camus, like in The Outsider.)

Look, this is deadly serious business.  There better be something really substantial in any indictment: and no, being short deals with bad names doesn’t count as substantial.

And even if there was wrongdoing, as I wrote in the Goldman post, indicting firms is an inefficient way to go.  Let those allegedly victimized make their case in court and collect damages.  The fallout from criminal indictments would be disproportionate and indiscriminate.

* It would be ironic if a deal named after Andrew Jackson would bring down a big bank.  And who in their right mind would name anything after James Buchanan, arguably the worst president in US history/

So there is no confusion, like Felix Salmon I believe that even if the trade or trades that precipitated the crash-boom (“the proximate cause,” as FS puts it) originated in the eMini, it is a matter of little moment with no particular regulatory implications.  The whole point is that in a tightly coupled system, under certain conditions (perhaps not typical conditions, but possible ones), a small shock in any one part of the system can have disproportionate effects throughout the system.  The financial markets are tightly coupled; arbitrage and quasi-arbitrage possibilities provide incentives to connect markets in related instruments.  Under most circumstances, that is a good thing.  Under some circumstances, this tight coupling can lead to non-linear responses.

The important phrase is “in any one part of the system.”  There are critical parts of the system that are more likely to be the proximate causes of a non-linear response.  In the financial markets, index products, which include ETFs like SPDRs, index options, and other products in addition to index futures, are more likely to be proximate causes because they by their very nature have more interconnections with other parts of the system.  But it could be any of them.  Thursday maybe it was S&P futures (maybe not).  Some other day it might be OEX or SPDRs.  The very thing that makes them valuable tools, and heavily traded, is the same thing that makes them the likely place where a chain reaction begins.  But it has to be remembered that this is a systemic issue, and obsessing on any one part of the system is a mistake.  Indeed, it can lead to greater problems.

To emphasize, this means I am not picking on eMini or index futures.

I would also like to emphasize that to me the remarkable thing is how rapidly the market bounced back, and all on its own.  It is almost certain, and the initial evidence seems to support this, that index products were the most likely proximate cause for the bounceback.  The tight coupling worked in reverse too, and led to a rapid correction.  That’s a good thing.  The market exhibited remarkable self-corrective properties.

Finally, it bears repeating that events like Thursdays are almost always the result of a conjunction of disparate forces.  The key underlying factor was the Greek saga, and its effects on liquidity.  Gensler’s testimony today suggests that liquidity began to decline around 2:30.  With less capital committed to making markets, prices would have moved more in response to order flow.  Given the potential for positive feedbacks from options hedges (Gensler mentions greater hedging activity, but doesn’t specifically say it was option-driven) and stop orders, and the second round feedback between price moves and liquidity, the broad contours of a big price shock can be discerned.

So, (1) take a systemic perspective, and don’t obsess on any one particular piece of the system as the “cause” of the event, (2) be patient, and look at how conditions were evolving prior to the collapse and rebound in order to identify the conditions in which a garden variety trade originating in market X or market Y can lead to a non-linear response.

* Let me be clear.  I am not imitating one of Obama’s most annoying verbal tics.

Last week I conjectured that a likely starting place for the May 6 crash-boom was the index futures market.  The WSJ ran an article today that claims a 50,000 contract options trade (ironically from the firm associated with Nassim Taleb, of Black Swan fame) touched off the dive.  Eric Noll, an Executive VP at NASDAQ, has submitted testimony to the House Financial Services Committee that also fingers the eMini:

Second, the Chicago Mercantile Exchange was beginning to experience unusual trading activity in the “E-Mini June” at the same time equities markets were experiencing heavy trading in highly correlated equities.  As you can see in Figure 1, the E-Mini began experiencing heavy volumes and prices begin sinking rapidly at 2:42, just before equities prices sink rapidly.  At 2:45:30, E-Mini trading becomes so volatile that the Chicago Mercantile Exchange triggered an automatic 5-second trading halt in E-Mini futures.  The price of the E-Mini future immediately leveled off and began to climb rapidly.  Equities followed that pattern shortly afterwards.

The time lines between the stories don’t exactly line up: the 50K options trade (puts, presumably) was a little after 2:15, but the big action in the eMini occurred at about 2:42.

Felix Salmon is skeptical about the Black Swan link to this particular black swan: “Lots of options trades of that size take place every day, and just because this one happened just before the market fell doesn’t mean it was the cause of the crash.”  Fair enough: 50K cars is not a big deal on most days.  But “every day” and “May 6th” are not the same thing.  That’s kind of the point: a confluence of events particular to that date likely made the ordinary exceptional, and perhaps exceptionally destabilizing.

Put differently, the market went non-linear–chaotic–in that short period of time.  A key feature of non-linear systems is that small perturbations can have big, disproportionate impacts.  The butterfly flapping its wings and all that.  Or a black swan.

In these sorts of situations, chains of usually ordinary events can feed back on one another with destabilizing consequences.  Here’s one scenario.

The market was very turbulent due to the chaos in Greece and Europe.  (“Chaos” in the ordinary sense of the word, not the mathematical/scientific sense.)  Market makers had backed off in the face of this risk.  Markets were not as deep as usual.  An order comes in.  Maybe several in a row.  The price starts to break, and then the feedbacks kick in.  Options hedgers–including, perhaps, Barclays and others hedging the exposure from the options it had bought from Taleb’s fund–start selling as part of a dynamic hedging strategy.  That’s one positive feedback.  Some stops get triggered.  More positive feedback.  Prices get forced down some more.  Given the background volatility, in light of the big price move, market makers human and electronic begin to fade big time.  Liquidity dries up as a consequence, meaning that even small orders move prices a lot.  With dynamic option hedges and stops going on automatic, the process feeds on itself.  Through correlation algos and program trading systems, the price move in the futures pits is communicated to the cash markets.  And off we go.

My sense remains that a market-wide sell-off most likely started in a market index-based contract, not in a single stock, or even a handful of stocks.  Options-based stories, like that in the WSJ, make particular sense, because dynamic hedging can create the positive feedback that leads to non-linear responses to individually small shocks.

But the eMini story alone is not enough.  Like Salmon says, the market deals with that every day.  But an order or orders that would have been no big deal on ordinary days could have been a very big deal if liquidity was already low due to the uncertainty emanating from across the Atlantic.

It would be VERY interesting to see the evolution of the S&P futures and futures options order books on the 6th.  Part of the scenario I sketched out is that the books weren’t as deep as usual as market makers (whether HFT types, or guys sitting at their TT screens) had pulled back due to the uncertainty surrounding Europe.  (It would be interesting to look at other order books too, to see if the decline in liquidity was general.)

And if you want a very amazing demonstration of how liquidity had fled the market, you HAVE TO listen to this play-by-play of action in the eMini pit on the 6th.  One of the most incredible things I’ve ever heard.  I mean, you HAVE TO listen. (Man, it takes me back.)

At times, the market was quoted 10 wide, bid 1060 at 1070.  Normally this is a one-tick market; the bid-offer is a quarter point.  So the bid-ask was 40 times larger than usual.  That’s an illiquid market.  One can only imagine what other markets, normally less liquid than the eMini, were like.

The other fascinating thing about the recording is the incredibly rapid price rebound, with the price jumping by a point at a time in seconds–again, this in a market that usually moves in quarter points.

And note that this was an old school floor market, not some computerized market untouched by human hands.

The WSJ article also discusses the rebound, and supports my conjecture from the 6th: some of the demonized computerized traders played the role of the cavalry, and charged in to save the day by snapping up bargains:

Around 3 p.m., the selling pressure abated. Just as swiftly as the market fell, it recovered ground. One factor behind the swift recovery, traders say, were funds that use computers and formulas to sniff out bargains in the market. These funds swooped in on hundreds of cheap stocks, helping push the market higher.

In ’87, corporate stock repurchases brought the market from the depths.  I hypothesize that value-based quantitative strategies did it last Thursday.

There is a lot of data to be analyzed before a verdict should be rendered.  We are blessed, though, by a superabundance of such data.  An abundance that is the direct result of the computerization of the markets.  In reconstructing the ’87 Crash, it’s impossible to know what was in the order decks of the locals.  It’s also impossible to sequence events in time with any accuracy.  In reconstructing this one, the order books are computerized and time stamped to the fraction of a second.  It will be a massive data processing task, but it’s just that: the data are there to be processed.

In the meantime, withhold rushes to judgment about HFT or algos or computers or whatever.  Take statements like Noll’s with a grain of salt.  No doubt the exchanges will all go around singing a Chuck Berry tune:

It wasn’t me, Sheriff; Uh huh, Sheriff, it wasn’t me
Ah! It must have been some other body, uh uh, Sheriff, it wasn’t me

all the while pointing fingers at other exchanges and algos.  Let folks analyze the data, particularly the evolution of the order books and the flow of orders into those books.  The answer will come in time, and with more precision that has been possible in previous crashes.