Prof. Jayanth R. Varma's Financial Markets Blog

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Prof. Jayanth R. Varma's Financial Markets Blog, A Blog on Financial Markets and Their Regulation

© Prof. Jayanth R. Varma
jrvarma@iimahd.ernet.in

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Sun, 31 Oct 2010

Crisis related books

My favourite crisis related book, Raghuram Rajan’s Fault Lines won the Financial Times and Goldman Sachs Business Book of the Year award last week. That gives me an excuse to write about the various crisis related books that I have read. There are clearly many important books on the crisis I have not read, and so I cannot comment on them. My list is not therefore intended to be comprehensive.

First of all are the books that provide a theoretical analysis of the crisis in its entirety and not just a few aspects of it.

Then there are books that provide important but partial theoretical perspectives on the crisis.

The third category is books that provide a detailed factual narrative of the entire crisis.

Another important category of crisis books look at specific actors or groups of actors that made or lost a fortune in the crisis.

I now turn to official reports related to the crisis.

I have not mentioned the books on financial history without which one cannot make sense of the crisis at all. This however is a subject for a separate blog post that I hope to compose in the next few days. So in this post, I will confine myself to only one book in this genre – This Time is Different – by Carmen Reinhart and Kenneth Rogoff. This is a book that simply cannot be dropped from any reading list on the crisis

Postscript: I have cheated a little. Many of the books that I have mentioned have a long subtitle in addition to the main title that I have mentioned here. I was too lazy to type these subtitles; moreover, the title is usually much more pithy without the subtitle. I have also consciously avoided giving links to Amazon or any other book site for any of these books in the belief that any half decent search engine will make up for this omission.

Posted at 16:44 on Sun, 31 Oct 2010     View/Post Comments (3)     permanent link


Wed, 20 Oct 2010

Some more thoughts on the flash crash

I have written a number of times about the flash crash during the last five months (here, here, here, here, here, and here.) This post tries to put together the key issues as I see them.

Posted at 14:53 on Wed, 20 Oct 2010     View/Post Comments (3)     permanent link


Sat, 16 Oct 2010

More on Flash Crash Report

I have a column in yesterday’s Financial Express with a more detailed discussion about the flash crash report that I blogged about (here / here) last week.

The Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC), which regulate the US equity markets and equity futures markets respectively, have released a hundred page report on the flash crash of May 6, 2010. On the afternoon of May 6, the broad market index in the US dropped by over 5% in the space of less than five minutes only to bounce back in the next five minutes. Then, even as the broad index was recovering, several stocks crashed to near zero. For example, Accenture fell from $30 to $0.01 in the space of seven seconds and then snapped back to the old level within two minutes.

The worst sufferers were retail investors who found their orders executing at absurd prices. A retail sell order (possibly a stop-loss order) might have been triggered when Accenture was trading at $30, but the order might have ended up being executed at $0.01. Some, but not all, of the damage was undone when the exchanges cancelled all trades that were more than 60% away from the pre-crash prices.

The CFTC-SEC report claims that the crash was triggered when a mutual fund sold $4.1 billion worth of index futures contracts very rapidly. The mutual fund’s strategy was to sell one contract for every ten contracts being sold by other traders, so that it would account for 9% of all trades during each minute until the entire order was executed. The large order allegedly confused the high frequency traders (HFTs) who having bought from the mutual fund, found themselves holding a hot potato, and then tried to pass the potato around by trading rapidly with each other. The result was a sharp rise in the HFTs’ trading volume, and this higher volume fooled the mutual fund’s algorithm into selling even faster to maintain the desired 9% participation rate. This set up a vicious circle of sharp price declines.

This story makes for a great movie plot but in an official investigative report, one expects to see evidence. Sadly, the report provides no econometric tests like vector auto regressions or Granger causality tests on tick-by-tick data to substantiate its story. Nor are there any computer simulations (using agent-based models) to show that the popular HFT algorithms would exhibit the alleged behaviour when confronted by a large price-insensitive seller.

Moreover, the data in the report itself casts doubt on the story. More than half of the mutual fund’s $4.1 billion trade was executed after prices began to recover. And the report suggests that the hot potato trading was set off by the selling of a mere 3,300 contracts ($180 million notional value). In one of the most liquid futures markets in the world, $180 million is not an outlandishly large trade. Surely, there must have been such episodes in the past and if there is a hot potato effect, it must have been observed. The report is silent on this. Further, the one thing that HFTs are good at is analysing past high frequency data to improve their algorithms. Would they not then have observed the hot potato effect in the past data and modified their algorithms to cope with that? Finally, during the most intense period of the alleged hot potato trading, the HFTs were net buyers and not net sellers. This suggests that perhaps the potato was not so hot after all.

The analysis in the report is even more flawed when it comes to the issue that concerns retail investors most—the carnage of individual stocks that began two or three minutes after the index began its recovery. The report bases its conclusions, on this issue, almost entirely on extensive interviews with the big Wall Street firms—market makers, HFTs and other brokers.

Astonishingly, the regulator did not find it necessary to interview retail investors at all. This is like a policeman investigating a theft without talking to the victim. There is no discussion of whether retail investors were confused, misled or exploited. For example, the report dismisses concerns about delays in the public price dissemination because all the big firms subscribe to premium data services that did not suffer delays. If delayed data led to wrong decisions by retail traders, that apparently is of no concern to the regulators.

In the post-crisis, post-Madoff world, we expect two things from regulatory investigations. First, we expect regulators to have the capability to investigate complex situations using state-of-the-art analytical tools. Second we expect them to carry out an unbiased investigation without giving high-profile regulated firms undue importance.

On both counts, the CFTC-SEC report is disappointing. After five months of effort, they do not seem to have come to grips with the terabytes of data that are available. The analysis does not seem to go beyond presenting an array of impressive graphs. Most importantly, the regulators appear to still be cognitively captured by the big securities firms and are, therefore, reluctant to question current market structures and practices.

Posted at 06:03 on Sat, 16 Oct 2010     View/Post Comments (1)     permanent link


Sun, 03 Oct 2010

Flash crash report is superficial and disappointing

The joint report by the US CFTC and SEC on the flash crash of May 6, 2010 was released late last week. I found the report quite disappointing and superficial. Five months in the making, the report provides a lot of impressive graphs, but few convincing answers and explanations.

Consider the key finding:

Even if we were to accept the conclusion of the report that a mutual fund selling $4 billion of index futures in 20 minutes is an adequate explanation of the flash crash in the index markets, there is still the issue of what happened in specific stocks. The index began its recovery at 2:45:28 but the carnage in individual stocks happened a few minutes later at 2:48 or 2:49. The report attributes this to the withdrawal of liquidity by market makers at around 2:45. At this point, the report relies on extensive interviews with market makers and fails to substantiate key assertions with hard facts.

Some portions of the report look more like a journalist’s casual empiricism than the hard analysis that one expects in a fact finding report. For example, on page 66, there is a discussion of data about a single market maker that concludes with a whole string of tainted phrases: “If this example is typical ... it seems that ... This suggests that ... From this example it does not seem that ... ” I can understand all this five weeks after the crash, not five months later.

A few less important quibbles:

In conclusion, the report leaves me disappointed as regards the three critical questions that I asked myself after reading the report:

  1. How far does the report provide confidence to an investor that with the corrective action taken since May 6, 2010, market prices are reliable? I think the report is totally unconvincing on this score.
  2. Does the report provide evidence that the post-Madoff SEC (and CFTC) can analyze a complex situation and arrive at a top quality analysis? Despite the high calibre of resources that have been recruited into the SEC in the last year or two, the quality of the report leaves much to be desired.
  3. Does the report show that regulators have escaped cognitive capture by their regulatees? I am sorely disappointed on this score. The report draws on extensive interviews with traditional equity market makers, high-frequency traders, internalizers, and options market makers. Apparently, nobody thought it fit to interview retail investors to understand how market distortions and data feed delays affected their order placement strategies. For example, Nanex has claimed that the Dow Jones index was delayed by 80 seconds. Were retail investors who follow the Dow Jones thinking that the market index was still falling even when professionals could see that it was recovering? Did this cause panic selling? For a cognitively captured regulator, it is sufficient to report that “Most of the firms we interviewed ... subscribe directly to the proprietary feeds offered by the exchanges. These firms do not generally rely on the consolidated market data to make trading decisions and thus their trading decisions would not have been directly affected by the delay in data in this feed.”

Posted at 08:49 on Sun, 03 Oct 2010     View/Post Comments (1)     permanent link




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