Streetwise Professor

Last week the Senate passed the financial “reform” legislation, which now goes to a conference committee that will produce a bill that combines the Senate bill with that passed by the House months ago.  (Ironically, the vote came when I was at a very nice conference on financial regulation hosted by Notre Dame.)

The Senate bill is best measured in pounds rather than pages.  (Pounds of what I’ll leave to your imagination.)  It is comprehensive, and from what I can tell, it is comprehensively wretched.  Stephen Bainbridge, whose opinion I respect a good deal, strenuously objects to the nationalization of corporate governance embedded in some of the bill’s language.  The infamous Lincoln swaps provision, which I’ve written about, is a horror.  It is some kind of sick joke to remake the entire derivatives market–and the banking sector–with a transparently populist ploy heaved up by a rather undistinguished senator (but I repeat myself) from Arkansas in a desperate attempt to stave off a primary challenge.  (Said ploy being incompletely successful, with Blanche Lincoln facing a runoff against her more lefty opponent.  Which probably gives the provision continued life when it should be put out of our misery with all dispatch.  The joke is even sicker when one considers that if current polls are at all accurate, Lincoln will be demolished in the general election.)  The clearing mandate is also a disaster in waiting.

Rather than deconstruct the whole abortion, I’ll focus on a couple of (relatively minor, in the scheme of things) features that illustrate its intellectual incoherence.

The first relates to market manipulation.  Here is a place where Congress could do some good by rewriting the existing law.  As I’ve written extensively over the past 15 plus years, US manipulation law could use a serious overhaul.  I’ve made concrete recommendations, including in a recent article in the Energy Law Journal.

But instead of doing something reasonable, the Senate passed an amendment proposed by the aptly named Senator Cantwell that does the exact opposite of what I recommend in the ELJ piece.  Specifically, apparently lacking the ability to form an original thought, Cantwell and the Senate fire up the copy machine and essentially Xerox the anti-manipulation language in the Securities and Exchange Act.  The amendment (S3348) outlaws “any manipulative device or contrivance.”

Boy, that’s such a big help.  Makes things crystal clear, no?

Look, a major problem with US commodity manipulation law is its complete failure to define what is  manipulative, and to provide courts and commissions with any guidance as to just what kinds of conduct are manipulative, and what tests should be applied to make that determination.  In its attempt to ensure that the law is sufficiently broad to catch everything that could be construed as manipulative, Congress has instead passed language that is so vague that the law can hardly catch anything.  The amendment’s language does nothing to correct that.

Moreover, Cantwell sings paeans to the securities law’s anti-manipulation provisions and precedents, and the effects of previous utilization of similar language in other commodity manipulation laws:

This language in this amendment is patterned after the law that the SEC uses to go after fraud and manipulation; that there can be no manipulative devices or contrivances.

It is a strong and clear [not!] legal standard that allows regulators to successfully go after reckless and manipulative behavior.

This legislation tracks the Securities Act in part because Federal case law is clear that when the Congress uses language identical to that used in another statute, Congress intended for the courts and the Commission to interpret the new authority in a similar manner, and Congress has made sure that its intention is clear.

In the 75 years since the enactment of the Securities and Exchange Act of 1934, a substantial body of case law has developed around the words “manipulative or deceptive devices or contrivances.”

The Supreme Court has compared this body of law to “a judicial oak which has grown from little more than a legislative acorn.” It is worth noting that the courts have held that the SEC’s manipulation authority is not intended to catch sellers who take advantage of the natural market forces of supply and demand, only those who attempt to affect the market or prices by artificial means unrelated to the natural forces of supply and demand.

Mr. President, Congress granted the same antimanipulation authority to the Federal Energy Regulatory Commission in 2005 in the Energy Policy Act. We did this as a result of the Enron market manipulation. I am very proud of this legislation and its ban on manipulation in electricity and natural gas markets. I say that because there was a similar issue of deregulation of energy markets that led to the Federal regulators not doing their job.

Since we have implemented this language in the electricity markets, the Federal Energy Regulatory Commission, since 2005, has used its authority to conduct 135 investigations. Of those 135 investigations, 41 have resulted in settlements involving civil penalties or other monetary remedies totaling over $49 million.

Two investigations brought about enforcement actions against manipulation, one against Amaranth for $291 million—-

The PRESIDING OFFICER (Mr. Udall of Colorado). The Senator has used 5 minutes.

Ms. CANTWELL. Mr. President, I ask unanimous consent for an additional 1 minute.

The PRESIDING OFFICER. Without objection, it is so ordered.

Ms. CANTWELL. The alleged market manipulation brought enforcement action against Amaranth for $291 million in civil penalties and Energy Trading Partners for $167 million in civil penalties. That is just an example of what a statute with teeth and a regulatory entity can do to actually stop manipulation when given that authority.

Sigh.  There are so many things completely wrong with this it isn’t even funny.  Most importantly, the relevance of SEC precedent to commodity market manipulation is a cross between (a) completely non-existent, and (b) actively counterproductive.  Most importantly, as I point out in the ELJ piece, whereas the most important kinds of commodity manipulations are market power manipulations (e.g., corners) most securities manipulations are information/fraud driven.  The canonical securities manipulation is the pump-and-dump, which has nothing whatsoever to do with market power manipulation that should be the first order target of any commodity anti-manipulation measure.  So, the vaunted SEC precedents are worth exactly bupkus.  No, that’s too generous.  They will be actually counterproductive as enforcement attorneys and judges try to pound a market power manipulation peg into a fraud hole.

The ETP case that Cantwell mentions is a perfect example of this.  I was an expert for ETP in this case, and know it intimately; as an aside, Cantwell is less than accurate in her characterization of the outcome of that case, because the government settled for a lot less ($5 million to the government, plus a set aside of $25 million to pay potential settlements in third party lawsuits) than the $167 million figure she cites, and that was a let’s-get-this-behind-us-gift to FERC, which brought the case.  Substantively, the FERC had to twist itself into knots to try to characterize the conduct it found offensive into the “deceptive device or contrivance” category.  FERC’s theories, uhm, evolved, to put it mildly; actually “devolved” would be a better characterization.  At every iteration, I was reminded of Maxwell Smart: “Would you believe?”  (No, actually.)  Rather than being the shining example that Cantwell paints it to be, the ETP case was a perfect example of the fundamental idiocy of trying to export securities law manipulation concepts and precedents to the commodity markets.

Instead of improving manipulation law, the Cantwell amendment will make it worse, as hard as that is to believe.  I don’t know if I’ve ever written a more depressing sentence.

Cantwell focuses on intent.  But that isn’t the only problem with existing commodity manipulation law.  Artificial price and causation have also posed problems too.  But all are eminently fixable through an application of solid economics, as I discuss in more detail in the ELJ piece, and which I demonstrated in my book on manipulation in the mid-90s and my piece on the Ferruzzi squeeze from 2004.

Another poster child for the intellectual bankruptcy of the Senate bill is its provision to empower the CFTC to extend position limits to OTC energy derivatives.  I have pieces forthcoming in Regulation and the Swiss Derivatives Review analyzing speculation and position limits in commodity markets.  The title of the Regulation piece suffices to convey the conclusions: “No Theory?  No Evidence?  No Problem!”  That is, the CFTC’s current proposal to impose position limits is not grounded in an understanding of the economics of commodity markets, and is completely unsupported by empirical evidence.  The same, obviously, is true of the provision in the just passed legislation.  But we’ll get limits nonetheless.

The Senate provision is particularly troubling because it will likely have effects on the Commission’s futures position limits as well as on OTC limits.  Fear of driving trading to the OTC markets restrained the Commission in its setting of the proposed limits, and led some Commissioners to express reservations about the entire effort.  With OTC position limit authority, those constraints and reservations evaporate.  Now the only competitive constraint on the CFTC is the threat of trading moving overseas.  But that threat is less severe than the competitive threat to the domestic OTC market, so it is quite possible that the Commission will impose more onerous restrictions on both exchange-traded and OTC-traded positions now that it has the OTC authority.

At the Notre Dame conference Chester Spatt warned of the unintended consequences of regulation.  Quite so.  And the Senate bill, and whatever comes out of conference, will spawn myriad unintended–but not unpredictable–consequences, most of them quite pernicious.  When the Insane Clown Posse (AKA the United States Congress) is done “reforming” our financial markets we’ll learn to our regret that however flawed our existing system is, it is a far, far better thing than the product of the constructivist irrationality of Dodd, Lincoln, Cantwell, and Frank et al.

My work on clearing was mentioned in the lead editorial in today’s Wall Street Journal.  For the most part, I agree with the editorial.  Hell, I could have written most of it.  It makes many of the points I’ve been writing about here on SWP, and in working papers and presentations, since the financial crisis began (and even before the crisis).  Even the initial sentence, which refers to the widespread belief that clearinghouses are a “miracle cure” echoes the title of my Regulation magazine piece from January, 2009–“The Clearinghouse Cure.”

The initial point is the most telling one: if clearinghouses make counterparty risk disappear (as its cheerleaders repeatedly suggest) why is there need for any CCP to have access to the Fed discount window?

Exactly.  They don’t make counterparty risk disappear.  They become repositories of counterparty risk that can fail, with potentially disastrous consequences for the broader financial system.

I was on board with the editorial until the last paragraph, in which the Journal says “Congress should strip out Mr. Dodd’s discount window provision. As important, Americans should understand that Congress isn’t ending financial risk in derivatives. It is merely redirecting that risk, while making taxpayers the ultimate backstop.”  Yes, it is merely redirecting that risk.  (Finally!)  No, it isn’t ending financial risk in derivatives.  (Finally!)  No, taxpayers should not be the ultimate backstop.  (Absolutely.)  But access to the Fed discount window does not mean a taxpayer bailout.  At least as long as the Fed acts as a traditional lender of last resort, along Bagehotian lines, lending to provide liquidity against good collateral.

During market shocks, large margin flows create spikes in the demand for liquidity.  It is appropriate for the Fed to accommodate such demands for liquidity through the discount window and market operations.  Bulking up clearinghouses through mandates, but denying them access to liquidity, is a recipe for disaster.

But one of the casualties of the financial crisis, and the Fed’s response to it (and even more so, the ECB’s response to the Greek crisis) has been the  devolution of the LOLR function.  Central banks have treated insolvency crises like liquidity crises, thereby socializing losses.

This is indeed a problem.  But it is a problem that is not limited to derivatives.  If Congress believes that it is a problem, it needs a thoroughgoing reform of the Fed.  Just denying CCPs access to the discount window will not fix it.

But back to the rest of the editorial.  Implicit in the whole debate over the relationship between CCPs and the Fed is the fact that the CCPs can fail.   If they fail, they can cause huge knock-on effects, just like the failure of a large dealer.  Potentially worse, in fact.  And this reality means that in the breech, it is likely that by hook or by crook Congress or the Treasury or the Fed will find some way to bail out a failing CCP.

This is an issue that Congress and the administration have refused to acknowledge.  In his speech at the ISDA Annual General Meeting in San Francisco, Deputy Treasury Secretary Neal Wolin pointedly refused to admit that clearing mandates could create too big to fail institutions, thereby exposing taxpayers to losses.  This refusal to recognize the very real consequences of a clearing mandate is sowing the seeds for the next crisis.

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?

For those with way too much time on your hands, and the big cable or satellite package with the obscure channels, I’ll be on Fox Business News at 12 Eastern, 11 Central tomorrow (Friday, May 12) to discuss last Thursday’s market boomerang.

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.

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.