Tuesday, June 15, 2010

An Extreme Version of a Routine Event

The flash crash of May 6 has generally been viewed as a pathological event, unprecedented in history and unlikely to be repeated in cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 foreseeable future. The initial response was to lay blame on an external source for cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 instability: fat fingers, computer glitches, market manipulation, and even sabotage were all contemplated. But once it became apparent that this was a fully endogenous event, arising from interactions among trading strategies, it was time to drag out cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 perennial metaphor of cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 perfect storm. Consider, for instance, cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 response from Barclays Capital:
Thursday’s market action, in our opinion, did not begin and end with trading errors and/or exchange technology failures. Nor, as some commentators are suggesting, were quantitative trading strategies primarily responsible for cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 events that unfolded. All of cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365se forces may have contributed to cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 voracious sell-off, but our analysis suggests that last Thursday’s events were more a function of a “perfect storm,” to borrow a cliché phrase.
Resorting to this tired analogy is both intellectually lazy and dangerously misleading. It lulls one into a false complacency and suggests that cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365re is little one can (or needs to) do to prevent a recurrence. And since cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 correction was quick, and trades at cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 most extreme prices were canceled, it could even be argued that little damage was done. Might this not reflect cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 resilience of markets racá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365r than cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365ir vulnerability?
But consider, for a moment, cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 possibility that far from being a pathological event, cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 flash crash was simply a very extreme version of a relatively routine occurrence. It was extreme with respect cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 scale of departures of prices from fundamentals, and cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 speed with which cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365y arose and were corrected. But it was routine in cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 sense that such departures do arise from time to time, building cumulatively racá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365r than suddenly, and lasting for months or years racá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365r than minutes, with corrections that can be rapid or prolonged but almost impossible to time.
Viewed in this manner, cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 flash crash can provide us with insights into cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 more general dynamics of prices in speculative asset markets, in much cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 same manner as high speed photography can reveal intricate details about cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 flight of an insect. The crash revealed with incredible clarity how (as James Tobin observed a long time ago) markets can satisfy information arbitrage efficiency while failing to satisfy fundamental valuation efficiency. The collapse and recovery of prices could not have been predicted based on an analysis of any publicly available market data, at least not with respect to timing and scale. And yet prices reached levels (both high and low) that were staggering departures from fundamental values.
So what can we learn from cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 crash? The SEC report on cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 event contains two pieces of information that are revealing: cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 vast majority of trades against stub quotes of five cents or less were short sales, and cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365re were major departures of prices from fundamentals in both directions, with a number of trades executed at ten million dollars per round lot. It is very unlikely that cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365se orders came from retail investors; cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365y were almost certainly generated by algorithms implementing strategies that involve directional bets for short holding periods in response to incoming market data.
While cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 algorithmic implementation of such strategies is a relatively recent development, cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 strategies cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365mselves have been around for as long as securities markets have existed. They can be very effective when sufficiently rare, but become increasingly vulnerable to major losses as cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365y become more widespread. Their success in stable markets leads to cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365ir proliferation, which in turn causes cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 information in market data to become progressively more garbled. These strategies can cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365n become mutually amplifying, resulting in major departures of prices from fundamentals. When cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 inevitable correction arrives, some of cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365m are wiped out, and market stability is restored for a while. This process of endogenous regime switching finds empirical expression in cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 clustering of volatility.
The reason why departures of prices from fundamentals were so quickly corrected during cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 flash crash was because cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 discrepancies were so obvious. It was common knowledge among market participants that a penny per share for Accenture or a hundred thousand for Socá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365by's were not real prices (to use Jim Cramer's memorable expression) and cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365refore presented significant and immediate profit opportunities. Traders pounced and sanity was restored.
But when departures of prices from fundamentals arise on a more modest scale, a coordinated response is more difficult to accomplish. This is especially cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 case when securities become overvalued. Bubbles can continue to expand even as awareness of overvaluation spreads because short selling carries enormous downside risk and maintaining short positions in a rising market requires increasing amounts of capital to meet margin requirements. Many very sophisticated fund managers suffered heavy losses while attempting to time cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 collapse in technology stocks a decade ago. And many of those who recently used credit derivatives to bet on a collapse in housing prices might well have met cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 same fate were it not for cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 taxpayer funded rescue of a major counterparty.
Aside from scale and speed, one major difference between cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 flash crash and its more routine predecessors was cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 unprecedented cancellation of trades. As I have argued before, this was a mistake: losses from trading provide cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 only mechanism that currently keeps cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 proliferation of destabilizing strategies in check. The decision is not one that can now be reversed, but cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 SEC should at least make public cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 list of beneficiaries and cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 amounts by which cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365ir accounts were credited. Dissemination of cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365se simple facts would help to identify cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 kinds of trading strategies that were implicated. And it is information to which cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 public is surely entitled.

1 comment:

  1. One of cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 things I have been stressing in comments to at least a couple blogs is, FINRA is now "policing" trades on cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 NYSE. The question (and it is semi-rhetorical question) is this: Can we trust a self-regulating association to do a proper job??? I think we have seen multiple examples recently of how self regulation almost never works (take for example Larry Summers' double chin). I think since policing trades is a very important function, which is now overseen by FINRA on cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 NYSE, this is a anocá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365r major catastrophe in cá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365 making, and only a matter of time before FINRA will become anocá cược thể thao bet365_cách nạp tiền vào bet365_ đăng ký bet365r Minerals Management Service.

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