Streetwise Professor

May 11, 2010

Let Me Be Clear*

Filed under: Derivatives,Economics,Exchanges,Financial crisis,Politics — The Professor @ 5:09 pm

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.

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  1. emini was fine, orderly. .25 tick wide spread all the way up and down. market fragmentation on the SEC side caused the crash. Eminis had a massive surge in volume because no one could get anything done on the SEC side-there was a flight to quality-quality of systems.

    Comment by Jeffrey Carter — May 13, 2010 @ 6:00 pm

  2. Not quite, Jeff. Duffy says that yes, for most of the time it was a .25 point spread, but at one point the spread was 26 ticks. Moreover, there was evidently little depth at the inside market. One 150 lot order moved the market 3 points, another moved it 3.75.

    The ProfessorComment by The Professor — May 13, 2010 @ 9:48 pm

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