Category: Miscellaneous News

Miscellaneous News

BofA Maple Sub-Debt: Pretend-Maturity Will Be Ignored

Boyd Erman of the Globe & Mail reports in a piece titled Bank of America shocks Maple market:

Bank of America (BAC-N12.680.342.76%) has broken an unwritten rule and shocked the Canadian bond market by deciding not to redeem a $500-million bond issue.

But the unwritten, wink-and-nod agreement with the investors who bought them was that the bonds would be called at the end of five years so that investors would never have to face the lower rates.

Bank of America has decided not to call the bonds and will take advantage of the lower rates. For investors in the bonds, it means lower prices and lower interest income, and a tough decision about what to do next.

My suggestion is that they make a note to read the terms of the issue next time, but what do I know?

The bonds were originally sold with a coupon of 4.81 per cent. Now, under the floating structure, they will pay interest rate at a short-term benchmark plus a fraction of a percentage point. At the moment, that works out to about 1.8 per cent.

The bonds are now being quoted at about 96 to 97 cents on the dollar by some desks after being marked at par in the days before this on expectations that they would be called at 100 cents on the dollar, market sources said.

The comments on the Globe site are a hoot.

There’s not much information available on this issue, but it’s mentioned briefly in the RBC-CM Maple Guide of 2H08 – with all the pseudo-analysis based on a certainty of call, of course, as is usual with subordinated debt.

I last reviewed this topic in the post Bank Sub-Debt Redemptions.

Miscellaneous News

TMX to Report Closing Quotes … Someday

Readers will remember that quotes provided by the TMX at the “end of the day” are not closing quotes: they are “last” quotes, measured at 4:30. They will differ from the Closing Quotes measured at 4:00 because orders may be cancelled, but not added, during the extended trading session – the one exception being that you can add as many orders as you like at the Closing Price.

I brought this to the attention of the TMX (I don’t think they’d ever really thought about it; my suspicion is that the code that worked perfectly well when there was not extended trading session simply got overlooked when the ETS was invented … put that is pure speculation on my part). The TMX took a survey of their customers and:

While we are not in a position to disclose survey results, we can tell you that there was limited interest from our clients with respect to the 4:00 PM closing bid/ask information. We are following up on adding 4:00 PM close bid/ask data to our end-of-day Trading Summary products and Market Data Web – Custom Query product. However, due to other development commitments and priorities, we can not say when this will be implemented.

I’m rather surprised and can only assume that the surveys were completed by database dorks rather than end users, because the Last Quote is only useful insofar as it reflects the Closing Quote – it has absolutely zero independent value.

I’m also surprised that there will be a potentially significant delay in giving users the option. I’ve never had the chance to examine the TMX code, so obviously I’m speculating again … but retrieval, storage and dissemination of Closing Quotes seems like a fairly trivial database operation. I don’t understand how implementation could possibly take more than a day.

I will, on occasion, spend some actual money to buy the “Trades and Quotes” output from the TMX – but not very often, because there is a charge for each quote and there can, conceivably, be several thousand quotes per minute. However, this will rarely be reported on PrefBlog in a timely manner, because I am separately advised that my problems nailing down IAG.PR.C on March 25 and CM.PR.K on March 28 were due to uploading schedules – detailed quote data is only put on DataLinx overnight, not within a few hours of the close.

Miscellaneous News

SplitShare Capital Unit Debate

Assiduous Readers will remember that I was quoted in a recent article by John Heinzl expressing a strong opinion on the Capital Units issues by SplitShare corporations:

For those reasons, Mr. Hymas says the capital shares are only appropriate for “suckers.”

This statement has attracted a certain amount of commentary and I have received some material criticizing my views. All further quotes in this post have been taken, in order, from an eMailed commentary – it has been interspersed with my commentary, but is quoted verbatim and in its entirety.

Response to “Ups and Downs of Doing The Splits” – John Heinzl, Globe and Mail, March 2, 2011

I have had a lot of involvement in split shares over the last two years, and I have to differ markedly from the assessment of Mr. Hymas, who prefers the preferreds to the capital units. I believe the exact opposite to be the case.

The split-share preferreds have limited upside, yet unlimited downside. They are essentially equity investments with a ‘preferred share’ wrapper. Most have downside protection to some degree, but rest assured, they can fall pretty well as much as the equity market can.

Asymmetry of returns is a feature of all fixed income, not simply SplitShare preferreds. Naturally, they can default, and one must take account of the chance of default: but firstly most will have Asset Coverage of at least 2:1 at issue time – meaning that the underlying portfolio can drop by half before the preferred shareholders take any loss at all – and secondly the Capital Unitholders will be wiped out before the preferred shareholders lose a penny.

No, there are no guarantees – there never are. But the preferreds have at issue time a significant amount of first-loss protection provided by the Capital Units.

The capital units are a whole other story. In my view they offer the BEST deal out there.

Imagine if you had a $100,000 portfolio of Canadian equities. You are totally exposed to the performance of the underlying assets, so a market fall of 50% takes an equivalent bite out of your assets. Now suppose instead you invest in a capital share with the following characteristics: leverage factor is 3.75 times. Discount to NAV is 20%. Maturity is 3 years. (These numbers are most assuredly achievable).

These numbers can be illustrated by the following:
Preferred Par Value: $10.00
Whole Unit NAV: $13.64
Price of Capital Units: $2.91

However, the capital units are issued at a premium to NAV (since they absorb all the issue expenses) of 5-10%. Thus, by choosing this example, you are to a degree saying that the Capital Units are only worth buying once they have lost about 25% of their value relative to NAV and have lost most of their NAV as well. I claim that this shows that the guys who paid full price for them are suckers.

While discounts of market price to intrinsic value are not unknown, they are by no means automatic. I gave a seminar on SplitShares in March, 2009 – the very height of the crisis! – and used the following chart to illustrate the fact that, even (or particularly!) when distressed, these things will generally trade at a premium to intrinsic value:


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The seminar was videotaped and is available for viewing (and downloading in Apple QuickTime format for personal use) for a small fee.

You could invest $26,667 in the capital units, and put the remainder in cash or investment grade bonds yielding , say, 3.5%. By doing so you get the same upside as the underlying assets.

Actually, it will be a bit better, because at maturity the discount will be made up, so you get an extra kicker of 6% per year. But in the event of a 50% fall in the market, although you would probably lose all of the value of the capital units, your cash would remain at $73,333, plus interest. You have dramatically outperformed on the downside, losing about 27% vs. 50%.

Yes, certainly, but you are not looking at the situation at issue time. You are looking for a distressed situation, in which somebody (the sucker) has already taken an enormous loss, not just on the NAV but also on the market price relative to NAV. Your illustration relies on the same presumption as the attractiveness of the preferred shares: the willingness of the sucker to take the first loss.

Not all split share capital units are attractive: some trade at premiums, and offer little leverage. Remember, these things are effectively long-dated options or warrants, although – even better – they can receive dividends. Any option or warrant calculator will tell you that if the capital units are priced correctly they should trade at a premium, not a discount, especially when leverage increases.

I discussed the valuation of Capital Units as options in my Seminar on SplitShares and provided the following charts. The first shows the theoretical value – given reasonable assumptions regarding volatility – of the capital units as the Whole Unit NAV changes. I will also note that this computation of theoretical value ignores all of the cash effects in the portfolio – dividends in, dividends out, fees and expenses out and portfolio changes to offset these effects – that will, in general, reduce the attractiveness of the Capital Units.


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The second shows the premium of expected market price over intrinsic value as the NAV changes:


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Instead, over the last few years I have seen cases where capital units offered leverage of up to 20 times, and yet still traded at a discount to NAV. That remarkable set of circumstances enabled investors to replace all-equity portfolios with a capital shares and cash combination portfolio which limited their equity exposure, and hence risk, to a fraction of what would otherwise be the case. Yet without losing any upside.

The remarkable paradox about capital units is that the higher the leverage, and hence the risk, in these things, the more one can reduce portfolio risk.

Scott Swallow, Financial Advisor
Manulife Securities Incorporated

Scott, I suggest that the critical element of your argument is the phrase “remarkable set of circumstances” and that, in the absence of such remarkable circumstances, our views are probably not very different.

Perhaps, as printed, my “sucker” epithet was too general – I certainly did not mean to suggest that all capital units were always bad all the time at all prices. If somebody offers to sell me capital units with an intrinsic value of $10 for a penny each, I’ll back up the truck! As I like to say, at the right price, even a bag of shit can be attractive: I buy fifteen of them every spring for my garden! So, perhaps I can be faulted for not qualifying my statement enough – but the reporter and I were talking about the issuance of these securities and he only had 1,000 words or so to work with – a full investigation of Split Shares takes considerably more space than that.

But your argument, as stated earlier, rests on the assumption that somebody else has taken a double loss – first on NAV, then on market price relative to NAV. I claim, that given the risk-reward profile of capital units at issue time in general, the IPO buyers (and most of those in the secondary market) are suckers.

Miscellaneous News

David Tremblay on Basel III Effects, Junk

The La Presse article mentioned on January 24 and in the comments to January 21 may have been identified!

Wind of change for equities (translation courtesy of Google):

Under the Basel III, the Bank for International Settlements, which monitors the financial stability around the world confirmed that the preferred shares that do not meet the new requirements will be phased out between 2013 and 2023.

To replace the existing preferred shares, banks will now issue the contingent capital. These titles are automatically converted into common shares if the bank becomes insolvent. Thus, holders of these securities pay the price, just as ordinary shareholders, should the unlikely situation where the government is forced to inject money to save the institution.

While this change was already planned, the news had a slight positive impact on the existing preferred shares: as they do not meet future requirements, banks will be more motivated to buy them. The preferred shares of banks that are trading at a discount currently should perform well in this context.

But it will take the next step is the confirmation by the Office of the Superintendent of Financial Institutions of Canada, for treatment of these instruments in the Canadian context.

… which isn’t quite the ringing endorsement I had been led to expect, but it is an endorsement and it was published in La Presse, so it’s the best suggestion so far.

I have previously published a review of Basel III effects on PrefBlog, with more depth in the January, 2011, edition of PrefLetter. Note that the La Presse article was published on January 15, after the awesome events of January 13 and January 14, but presumably the interview was conducted prior to this.

Mr. Tremblay, the PM for Omega Preferred Equity Fund, had some very sensible things to say about junk FixedResets:

I suggest to be careful with certain adjustable rate preferred shares that were issued in recent years. Their dividend adjusted every five years, depending on interest rates, which protects investors against the risk of rising interest rates which would lose value in preferred shares.

But shareholders are not protected against credit risk. These securities houses of perpetual preferred shares (no redemption at the option of the holder). We must carefully analyze the credit risk of the issuer if you do not want to be stuck with a bad credit forever!

Ask your advisor if he has done his homework, particularly for preferred shares with a credit valued at P3. On a scale from P1 to P5, titles that get a rating of P1 and P2 are the strongest. At P3, some issuers are good, others less. It must be very selective, buying preferred shares that are trading at a discount and that offer acceptable credit risk.

Miscellaneous News

More on the TMX Close != Last

In the post TMX “Last” != “Close” I pointed out that the data published all over the web overnight does not actually represent closing quotations: it represents “Last” quotations, which differ mainly in that cancellations during the extended trading session can make the quote worse than it really was. In some (rare) cases, they can shift dramatically, if the closing bid (ask) is also the Last Sale Price and it is hit (lifted) by orders exceeding those available to fill it during the extended session (e.g., 25.00-10, 5×5 “Close”, with Last Sale = 25.10, could turn into 25.10-20, 10×5 “Last” if a bid for 1500 at 25.10 came in during the extended session and nothing else happened.

Anyway, as explained, this is important not just for quantitative back-test purposes, but for accounting reasons, as many funds use the “Last” quote thinking it is the same as the “Close” quote, and in any case are required to reconcile to the most recent active market quote for financial statement purposes.

So I asked an accountant – what would be the reconciliation bid for GWO.PR.J on December 2 – And I got this:


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So Bloomberg is clearly reporting the “Last” – not the “Close” – which is hilarious, as the extreme laziness of most portfolio managers has rendered them helpless and confused without a Bloomberg terminal. As previously explained:

A closing quote is considered to be the quote at the close of the regular trading session at 4pm. Market Maker responsibilities end at 4pm. The actual closing quote at 4pm on Dec.2 for this issue was 27.04 – 27.54.

So are these reconciliations what they purport to be? Does anybody care? Stay tuned!

Update, 2014-5-30: For more, see TMX to Report Closing Quotes … Someday.

Miscellaneous News

TMX: Close, Schmose!

Assiduous Readers will recall that MAPF’s reported performance for December was measurably impacted by a bad closing quote on SLF.PR.E: the quote was 19.91-60, 2×27.

I noted that I had sent an email of inquiry to the TMX regarding this quote; they have finally answered (it only took ten days and one follow-up!). My eMail is in reguar font; the TMX’s responses are in italics:

i) Who is the market-maker for this security?

W.D. Latimer Co. Ltd.

Not the world’s most plugged-in dealer.

ii) Will the TMX be investigating the circumstances that led to the wide spread on this closing quotation?

The Quote widened due to a couple of bids being cancelled for a mere 7 seconds prior to the close.

So here the TMX is saying there is nothing wrong or unusual with a latency of 7,000 milliseconds, As long ago as 2007, Reuters reported:

“The standard now is sub-one millisecond,” said Philadelphia Stock Exchange CEO Sandy Frucher. “If you get faster than sub-one millisecond you are trading ahead.”

About eighteen months ago, the standard for executing a trade was around five milliseconds, he said. A millisecond is one-thousandth of a second.

I think we can conclude that there was plenty of time for WDLatimer to respond to the market, if they had felt like it.

iii) Will the TMX be announcing the results of such an investigation?

See ii)

What a great investigation that was.

iv) Will the TMX be implementing any sanctions against the market makerfor this security?

No. TSX Market Making Rules require Market Makers to monitor spreads and react in a reasonable time frame when a spread increases beyond an agreed upon spread goal. A 7 second time frame particularily right at the close would not warrant any sanctions. Market Makers are monitored for performance on a monthly basis in terms of Average Time Weighted Spread as compared to an agreed upon Spread Goal, and also for number of Spread Goal violations per month and average time of those violations. A habit of violating this performance parameters would certainly be caught and addressed.

‘Trust us! We’re the Exchange!’

In response, I have sent the following eMail to the TSX:

Thank you for your reply. It raises the following further questions:

i) You refer to the the time span of the closing quote for this issue as being “a mere seven seconds”, and claim that Market Makers are required to react in a “reasonable time frame when a spread increases beyond an agreed upon spread goal”. It is my understanding that seven seconds is sufficient time for an algorithm to analyze and react to thousands of such situations.

a) What is the current TSX standard for “reasonable” in this context?

b) When was the TSX Standard for “reasonable” last reviewed?

c) What is the “spread goal” for SLF.PR.E

ii) You deprecate the importance of closing quotations with your statement “A 7 second time frame particularily right at the close would not warrant any sanctions.”

a) Which times during the trading day are considered most important by the TSX in assessing Market Maker performance, and how does the importance of these times compare to the importance of the close?

b) As you may be aware, the CICA requires reporting in financial statements of the valuation of Funds according to the closing quote. Does the TSX take a view on the appropriateness of using the close, given its apparent deprecation when monitoring Market Maker performance?

iii) You claim that “Market Makers are monitored for performance on a monthly basis in terms of Average Time Weighted Spread as compared to an agreed upon Spread Goal, and also for number of Spread Goal violations per month and average time of those violations. A habit of violating this performance parameters would certainly be caught and addressed.”

a) Where are the results of the monitoring process published?

b) How does the Average Time Weighted Spread take account of the reduced importance of quotations near the close?

c) How many violations of the Market Maker performance parameters were caught and addressed in calendar 2010?

Thank you for your attention to this matter.

Miscellaneous News

HPR: Horizons AlphaPro Preferred Share ETF

The TMX has announced:

Horizons AlphaPro Preferred Share ETF (the “ETF”) – An application has been granted for the original listing in the Industrial category of 1,015,000 Class E units (the “Units”) of the ETF, all of which will be issued and outstanding, and none will be reserved for issuance upon completion of an initial public offering.

Listing of the Units will become effective at 5:01 p.m. on Monday, November 22, 2010 in anticipation of the offering closing prior to the opening on Tuesday, November 23, 2010. The Units will be posted for trading at the opening on November 23, 2010.

Horizons AlphaPro has announced:

AlphaPro Management Inc. (“AlphaPro”), manager of the Horizons AlphaPro exchange traded funds (“ETFs”), has launched Canada’s first actively managed preferred share ETF, the Horizons AlphaPro Preferred Share ETF (the “Preferred Share ETF”).

The Preferred Share ETF will begin trading today on the Toronto Stock Exchange under the symbol HPR. The sub-advisor to the Preferred Share ETF is Natcan Investment Management Inc. (“Natcan”), which currently manages more than $1 billion dollars in preferred share assets.

“We’re very happy to be working with Natcan once again. Their fixed income team has done a great job in managing the recently launched Horizons AlphaPro Corporate Bond ETF, Canada’s largest actively managed ETF. We expect more of the same with the Preferred Share ETF based on our belief that an active strategy can overcome many of the limitations found in trying to replicate a preferred share index,” said Ken McCord, President of AlphaPro.

The investment objective of the Preferred Share ETF is to provide dividend income while preserving capital by investing primarily in preferred shares of Canadian companies. The Preferred Share ETF may also invest in preferred shares of companies located in the United States, fixed income securities of Canadian and U.S. issuers, including other income generating securities, as well as Canadian equity securities and exchange traded funds that issue index participation units. The Preferred Share ETF will, to the best of its ability, seek to hedge its non-Canadian dollar currency exposure to the Canadian dollar at all times.

Natcan anticipates yields on investment grade preferred shares will stay strong over the next two years and that the asset class will likely continue to see a growth in interest from income seeking retail investors, many of whom are looking to increase their income in retirement. This process could be accelerated by the phase-out of many income trusts in 2011 and beyond.

“Preferred shares really hit a sweet spot for many Canadian investors,” Mr. McCord said. “They offer attractive, tax-efficient yields and are generally less volatile than common shares. For investors with a need for income and an appropriate risk tolerance, preferred shares can be a very effective investment solution.”

The Preferred Share ETF has closed the offering of its initial units and will begin trading on the Toronto Stock Exchange when the market opens this morning.

The prospectus, on SEDAR under Investment Funs, dated 2010-11-19, states:

The investment objective of the AlphaPro Preferred Share ETF is to provide dividend income while preserving capital by investing primarily in preferred shares of Canadian companies. The AlphaPro Preferred Share ETF may also invest in preferred shares of companies located in the United States, fixed income securities of Canadian and U.S. issuers, including other income generating securities, as well as Canadian equity securities and exchange traded funds that issue index participation units. The AlphaPro Preferred Share ETF will, to the best of its ability, seek to hedge its non-Canadian dollar currency exposure to the Canadian dollar at all times.

To achieve AlphaPro Preferred Share ETF’s investment objectives, the ETF’s Sub-Advisor will use fundamental research to select companies that, based on the Sub-Advisor’s view on the company’s industry and growth prospects should be included in the ETF’s investment portfolio. An extensive credit analysis for each security as well as an assessment of each company’s risk profile is completed in order to confirm the selection and relative weight of each security held by the ETF. The AlphaPro Preferred Share ETF will primarily invest in the preferred securities of Canadian issuers whose debt, generally, at a minimum, have an investment grade rating at the time of purchase.

The AlphaPro Preferred Share ETF may also invest in Canadian equity securities that have attractive dividend yields and Listed Funds that pay dividend income. In anticipation of or in response to adverse conditions or for defensive purposes the AlphaPro Preferred Share ETF may temporarily hold a portion of its assets in cash, money market instruments, bonds or other debt securities generally not to exceed 20% of the ETFs net assets.

[Management Fee] 0.55% of the net asset value of the AlphaPro Preferred Share ETF

Natcan, the Sub-Advisor of the AlphaPro Corporate Bond ETF, the AlphaPro Preferred Share ETF and the AlphaPro Floating Rate Bond ETF is an affiliate of NBF and NBF holds an indirect minority interest in the Manager. As a result, Natcan may be considered to be an associate of the Manager.

Since 2009, Marc-André Gaudreau, has been Senior Vice-President of Natcan. Mr. Gaudreau, has more than 12 years of investment management and credit markets experience and has been with Natcan since 2004. From 2005 to 2009 Mr. Gaudreau was Vice-President, Corporate Bonds and Income Funds of Natcan.

Roger Rouleau, Vice President, Fixed Income of Natcan, has more than 4 years of fixed income research and investment management experience. Mr. Rouleau has been with Natcan since 2007 and from 2005 to 2007 was a Research Associate with RBC Capital Markets.

Mathieu Lachance, Vice President, Fixed Income of Natcan, has more than 7 years of experience in the financial markets industry. Before joining Natcan in 2009, he worked in the fixed income arbitrage sector of the Ministère des finances du Québec and as assistant index portfolio manager and derivatives trader at PSP Investments. Mathieu also has extensive experience with derivative products.

Regretably, the prospectus does not specify the track records of these individuals or their firms, despite the fact that Natcan “currently manages more than $1 billion dollars in preferred share assets.”

Unfortunately:

Mutual fund regulations restrict the presentation of performance figures until a fund reaches its one-year anniversary.

… but I will report performance once it becomes available.

Update: Jonathan Chevreau reports:

Natcan will also hold some floating rate preferred shares to protect against rising interest rates: Floating rate preferreds are not included in the S&P/TSX Preferred Share Index tracked by the passive rivals.

DPS.UN has lots of floaters; so I suppose it must be classified as active.

The management fee is 0.55%. Estimated weighted average yield of the securities at inception are 5.5%, with minimum credit quality of P-3/BBB.

Current Yield, obviously.

Miscellaneous News

Flash Crash Report Criticism Continues

Hal Weitzman of the Financial Times highlights a purported Need for consistent market structure to avoid ‘flash crash’:

Gary Katz, head of the International Securities Exchange, owned by Deutsche Boerse, dismissed the suggestion that US regulators should focus on creating incentives for market-makers.

“When the market begins to fall like that, there are no incentives big enough to persuade market-makers to catch a falling knife,” Mr Katz said.

Tom Whittman, president of Nasdaq OMX, which operates one of the biggest US options-trading platforms, agreed. “Market-makers wouldn’t have stayed in the market on May 6,” he said. “They’d rather pull out and pay a fine.”

Ed Boyle, who runs NYSE Euronext’s options business, said the “flash crash” indicated there were bigger and more serious structural issues for regulators, such as the existence of “dark pools” for share trading.

“There has to be a more consistent market structure than simply incentives for market-makers,” Mr Boyle said.

Bill Brodsky, chief executive of the Chicago Board Options Exchange, said the Securities and Exchange Commission’s report on the “flash crash”, which pinpointed a single trade by Waddell and Reed, a Kansas City-based firm, was suspect.

“The SEC never figured out what happened on May 6,” Mr Brodsky said. “The SEC report just doesn’t add up in my view.”

In the absence of any argument to support the idea that structural issues were at the root of the crash, I’ll have to dismiss Ed Boyle’s remarks as self-serving.

Brodsky’s remarks were also reported by Reuters:

“We went on for months and months and still didn’t know what happened,” William Brodsky, chief executive of Chicago Board Options Exchange parent CBOE Holdings Inc (CBOE.O), told a Futures Industry Association conference.

The report’s explanation of the May 6 crash “just doesn’t add up in my view,” he said on Thursday

Brodsky, who recently headed up the World Federation of Exchanges, criticized the report’s “vague reference to a Kansas City firm (Waddell),” adding, “we need to know what happened across all markets” that day.

“We failed because it took so long to figure out what happened, and they never figured out what happened,” he said of the CFTC and the SEC, which is expected to make further changes to the marketplace to avoid a repetition of the crash.

The Wall Street Journal continues to tout “order toxicity”:

“Complementary to circuit breakers based on price action, they could have circuit breakers based on our metric,” said Marcos Lopez de Prado, one of the authors of the study released last month and head of high frequency futures at hedge fund Tudor Investment Corp.

The study has already caught the attention of regulators as they look for ways to avoid another flash crash, especially given that Maureen O’Hara, one of the Cornell professors that co-authored the study, is a member of the Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues. The committee’s first task after it was formed in mid-May was to review the market events of May 6, when stock prices fell dramatically before staging a rapid rebound, and make recommendations related to market structure issues that may have contributed to that day’s volatility.

Richard Ketchum, chairman and chief executive of the Financial Industry Regulatory Authority, mentioned the study Friday during a meeting of the Joint CFTC-SEC Advisory Committee. Ketchum noted that a way for market participants to predict toxicity and hedge accordingly “could be really valuable.” The question, he said, is “how do you create an environment where people can offload some of that toxicity risk?”

That ain’t the question, Ketchum. The question is “is it possible to predict future toxicity?”. As has been noted on PrefBlog there is not a shred of evidence in the paper regarding predictive power of “Order Toxicity” – it’s just another piece of Technical Analytical gargage (fifty year old technical analytical garbage, at that) that explains everything and predicts nothing. But one of the authors has good political connections, so we haven’t heard the last of it.

Meanwhile, an executive with the CME has flatly contradicted a central element of the SEC report’s conclusions:

An algorithm-powered order to sell 75,000 futures contracts linked to the S&P 500 stock index, entered by a mutual fund as the session’s volatility ramped up, did take into account price and time parameters, according to Scot Warren, managing director of equity indexes for CME.

“This was a sophisticated algorithm that took time and price into consideration,” said Warren, contesting descriptions of the trade as an emergency bet that helped spark a rout in stock prices.

Warren said the session’s activity revealed a “fundamental supply and demand imbalance” that spooked buyers from the market.

The second paragraph above is a bit puzzling, because the part that says he is “contesting descriptions” is not a direct quote – it might very well be the reporter’s interpretation. If somebody really, really, needed to unload 75,000 contracts, then I am prepared to believe that the algorithm executed this task in an efficient manner – the same way I would unload 100,000 horribly illiquid preferred shares in a day if the client insisted on it (after acknowledging in writing that I considered it a really stupid idea!).

The question is, was it really in Waddell Reed’s clients’ best interests to unload 75,000 contracts as quickly as possible? With no limit price? That’s a $4.6-billion trade, which Waddell Reed has defended as being a highly astute hedge based on a keen awareness of risk. You mean to tell me they were $4.6-billion worried about the market in the afternoon of May 6 and were $0.00 worried in the morning? I’m prepared to listen, but to me the whole Flash Crash story is just another tale of a cowboy vaporizing his clients’ money.

The SEC report was discussed on PrefBlog in the post Flash Crash: Incompetence, Position Limits, Retail.

Miscellaneous News

Flash Crash: Nanex Continues Criticism of SEC Conclusions

Nanex has released its May 6’th 2010 Flash Crash Analysis Final Conclusion:

First of all, the Waddell & Reed trades were not the cause, nor the trigger. The algorithm was very well behaved; it was careful not to impact the market by selling at the bid, for example. And when prices moved down sharply, it would stop completely.

The buyer of those contracts, however, was not so careful when it came to selling what they had accumulated. Rather than making sure the sale would not impact the market, they did quite the opposite: they slammed the market with 2,000 or more contracts as fast as they could. The sale was so furious, it would often clear out the entire 10 levels of depth before the offer price could adjust downward. As time passed, the aggressiveness only increased, with these violent selling events occurring more often, until finally the e-Mini circuit breaker kicked in and paused trading for 5 seconds, ending the market slide.

The first large e-Mini sale slammed the market at approximately 14:42:44.075, which caused an explosion of quotes and trades in ETFs, equities, indexes and options — all occurring about 20 milliseconds later (about the time it takes information to travel from Chicago to New York). This surge in activity almost immediately saturated or slowed down every system that processes this information; some more than others. The next sell event came just 4 seconds later at 14:42:48, which was not enough time for many systems to recover from the shock of the first event. This was the beginning of the freak sell-off which became known as the flash crash.

In summary, the buyers of the Waddell & Reed e-Mini contracts, transformed a passive, low impact event, into a series of large, intense bursts of market impacting events which overloaded the system. The SEC report uses an analogy of a game of hot-potato. We think it was more like a game of dodge-ball among first-graders, with a few eighth-graders mixed in. When the eighth-graders got the ball, everyone cleared the deck out of panic and fear.

Zero Hedge reports the latest in an ongoing series of mini-flash crashes – Verifone on October 15:

Well, none really, suffice to say that we have just had approximately the 20th flash crash in the past 2 months (all in rehearsal for when Apple goes bidless). Don’t worry though – the SEC is all over it. And, after all this is to be expected when trading in a computerized, roboticized, broken market. But a point to consider: the NYSE decided to cancel all trades below $27.44, so to the unlucky human who bought at $27.43 tough luck. Of course, robotic readers who sold at that price: congratulations, the NYSE and SEC has your robotic back. We are now eagerly awaiting Monday’s ongoing flash crashes.


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Zero Hedge‘s take on the SEC report was:

NO ONE MUST BE ALLOWED TO SELL MORE THAN ONE SHARE OF STOCK AT A TIME EVER!!! YOU WILL OVERLOAD THE MARKET, FLOOD THE NYSE’S LRP, CAUSE A LIQUIDITY CRISIS, DESTROY THE MARKET AND END CIVILIZATION AS WE KNOW IT

aiCIO notes that the SEC report whitewashes the Exchange’s role in the Flash Crash, in a post titled The Saga Continues: Flash Crash Controversy:

Still, the report has brought a lot of this criticism on itself. The recommendations it does make, and even many of the conclusions it comes to, seem incommensurate to the problems of the crash. The fact that the NYSE’s computer systems couldn’t keep up with trading volume and printed delayed and inaccurate stock quotes? A couple brief references buried in footnotes and deep in the report saying things like, “we do not believe significant market data delays were the primary factor in causing the events of May 6.” And no harsh words for the exchanges or demands that they fix the problems.

What to do about the lightning-fast reselling of futures that certainly contributed to (and in Nanex’s analysis, caused) the Crash? It doesn’t say much. What about the upside of high-frequency trading, firms who actually stayed in the jittery market and provided liquidity during the Crash, only to have exchanges like the NYSE cancel their trades and cost them millions? The report codifies a byzantine set of standards for canceling future trades, but they seem too complex for most trader to take into account during real-time trading, and are fairly moot, since an exchange has the right to cancel any trade it wants to. So in the unfortunate event of a repeat crash, many traders might be so afraid of having their trades canceled again that they’ll simply pull out of the market entirely.

And finally there’s the the bigger question of What This All Means. “Despite the knee-jerk reaction on part of anybody who wanted to get on TV,” says Illinois Institute of Technology professor Ben van Vliet, a high-frequency trading expert who works with the Chicago Mercantile Exchange and CFTC, the report shows “that automated systems had nothing to do with it….There’s actually a much better argument that the reason the market came back so fast is automated trading systems. Automated systems, because they don’t trade on emotion, calculated the probabilities, [bought the undervalued securities] and that’s why things came back so quickly.”

Miscellaneous News

Flash Crash: SEC's Statement of Fact Challenged by Nanex

Nanex has published a very important post titled May 6’th 2010 Flash Crash Analysis; Continuing Developments; Sell Algo Trades:

We have obtained the Waddell & Reed (W&R) May 6, 2010 trade executions from the executing broker in the June 2010 eMini futures contract. There were 6,438 trades totalling 75,000 contracts. We matched them by time, price and size to the 147,577 trades (844,513 contracts) in the CME time and sales data between 14:32 and 14:52 (they matched exactly). One-second resolution charts of the W&R trades along with other eMini trades are shown below in various time frames.

The SEC report identified a Sell Algorithm selling 75,000 contracts as the cause of the flash crash. If the “Sell Algorithm” in the SEC report refers to the Waddell & Reed trades, then there is a problem. A big one. Looking at the trades in context with the other trades during that time, they do not appear to be significant. The W&R trades also do not occur near the ignition point (14:42:44.075) we identified earlier. Furthermore, the W&R trades are practically absent during the torrential sell-off that began at 14:44:20. The bulk of the W&R trades occurred after the market bottomed and was rocketing higher — a point in time that the SEC report tells us the market was out of liquidity. Finally, the data makes it clear that the algorithm does take price into consideration; you can see it stops selling if the price moves down over a short period of time.

Something is very wrong here.

There are some charts of great interest.

I quite agree that something is very wrong here. The SEC stated quite explicitly:

This large fundamental trader chose to execute this sell program via an automated execution algorithm (“Sell Algorithm”) that was programmed to feed orders into the June 2010 E-Mini market to target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time.

Let’s play lawyer. “Target” does not necessarily mean that the execution rate was achieved. It only means it was targetted, and it is possible that other considerations adjusted this target. “Without regard to price” is formally consistent with Nanex’s observations regarding the appearence of pauses in algo execution, since the pauses are triggered by the rate of price decline; it might be that “without regard to price” means simply that once the market price has flattened out it starts executing again, regardless of what level prices reached during the pause period.

But that’s just hair-splitting. I will be most disappointed if this SEC report turns out to have been an exercise in legalistic hairsplitting.

Now, it is not necessarily the case that the SEC report and conclusion is completely wrong, even given the execution pause; it is entirely possible that Waddell Reed soaked up all the available liquidity and the price decline triggered other things. In that case the SEC report is not wrong, per se, but it has missed the point of the affair which (assuming that the hypothesis is correct) is far different from the stated conclusions.

After all, if I put in a market order to sell 100,000 shares; execution of this order takes the market price down a buck; the decline in market price triggers stop loss orders of 200,000 shares which take the market price down another two bucks; and this decline in market price causes the momentum players to jump in with both feet while all potential buyers sit on their hands and the maret price declines another four bucks … what’s the cause of the seven dollar decline? Me, I would say “mainly bozo price-based technical traders”, but maybe the SEC would blame me for the whole thing.

The SEC needs to clarify this.

The story has been picked up by the New York Times:

The findings are based on the actual private trading data from the afternoon of May 6 given to Nanex by Waddell & Reed — presumably because Waddell & Reed wants the data to be made public to clear its name as the cause of the crash.

The data was verified for Nanex by Barclays Capital, at the request of Waddell & Reed.
Barclays Capital supplied the computer algorithm used by Waddell & Reed to make the sale.

In a statement, Waddell & Reed said, “Following the recent release of the regulatory report on the ‘flash crash,’ many market observers have noted that the events of May 6 involve multiple issues that transcend the actions of any single market participant. We agree with those observations.”

A spokesman said, “After discussion, we granted permission to use the data, which was supplied to us by the executing broker.”