PrefBlog

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.”

Roubine Global Economics has published an alarmist blog post titled The Flash Crash and Financial Terrorism: Could the Nineteenth Street NW Scenario Come True?:

But the SEC’s explanation is scarcely reassuring, and the incident is surely symptomatic of the pervasive market uncertainty.[1] That a single trade could wreak such havoc also raises the intriguing (and frightening) possibility of a deliberately engineered financial crash.
…
A recent account, Nineteenth Street, NW, describes one possible scenario in which the terrorists use an off-shore hedge fund to launch a series of speculative attacks. The terrorists start with already weak currencies or markets—perhaps an overvalued currency or an under-financed sovereign[2]—and as they succeed in their initial speculative attacks, not only do they gain additional capital to launch their next attack, they also induce other (profit, not politically, motivated) investors to join the bandwagon of the next round of speculative attacks. In the story, the terrorists are also able to learn of the central banks’ FX intervention strategies (an issue of growing salience once more)—and plan a nasty surprise at a meeting of central bank governors and ministers to really spook markets. Eventually, given the interconnectedness of the global financial system, these cascading crises culminate in a global financial crash—costing trillions of dollars, and millions their jobs, homes, and life-savings.

The account is purely fictional, of course, but as George Soros proved when he helped oust the UK pound from the European Exchange Rate Mechanism in 1992, weak fundamentals and jittery markets make for successful speculative attacks against even major central banks. And as the flash crash has amply demonstrated, markets are plenty jittery these days.

There’s so much here that is completely off-base I scarcely know where to begin. Terrorists launching speculative attacks via a hedge fund? Well, if they were that smart they wouldn’t be terrorists.

The Flash Crash caused 20 minutes of chaos, as the $4.1-billion market order swamped available liquidity, but the market quickly recovered. Dave Cummings estimates the cost of that adventure to be $100-million … and you can bet that the next twenty minutes would have cost more, given the lack of fundamental justification. Chaos inducing trades of this magnitude can only be done by sovereigns – China, say, the day before invading Taiwan. And in that event, you can bet the Fed would be involved, buying up Treasuries with fiat money as fast as the Chinese could sell.

Soros making a “successful speculative attack” in 1992? The UK owes Soros its heartfelt gratitude that he assisted in taking the pound out of the ERM. The attack was speculative, certainly, in the sense that there was no way of knowing for sure what was going to happen. But it would not have been successful had it been fundamentally unsound. What the events of September 1992 showed was that it was sterling’s position in the ERM that was unsound. Had they remained, the distortions would have spread from the financial economy to the real economy and things would have been, ultimately, much worse.

Which is the role of hedge funds and the role of short-trading: to yell that the emperor has no clothes. Politicians and global bureaucrats heartily dislike the entire process, because they’re the tailors. However, most of these attacks are unsuccessful because they are not based in fundamentals – they’re just chatter by wannabes.

The funny part about the essay is that the author acknowledges this:

Because the specific trigger is almost impossible to predict, crisis prevention efforts are better directed at addressing the underlying vulnerabilities. Quite simply, if there are no vulnerabilities, then a “triggering event” (deliberate or accidental) will have nothing to ignite, and will just fizzle out instead.

So who are the wise people who are going to make the system invulnerable, carefully ensuring that nothing bad can ever happen to anybody anywhere?

Starting from this premise, the Early Warning Exercise draws on a wide range of analytical tools, market information, and expert opinions. A key goal is to “connect the dots”—that is, understand how shocks in one country or market could spread across the global financial system. The findings are communicated confidentially to finance ministers and central bank governors at the IMF Spring and Fall meetings in order that they may take prompt preventive and corrective actions, especially those that require international cooperation and coordination.

Ah, yes, the IMF, perpetually on the prowl to expand its bureaucracy.

And who, you may ask, is raising the bogeyman of financial terrorism (as described in the novel Nineteenth Street NW) and pointing to the IMF as the saviour of the world? Funny you should ask:

Rex Ghosh is an economist with the International Monetary Fund and the author of Nineteenth Street NW (www.nineteenthstreetnw.com), a thriller about financial terrorism and a global market crash.

Roubini has demeaned himself by publishing this claptrap.