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.
- Of the books that I have read in this genre, the one that I liked the most was Raghuram Rajan’s Fault Lines. It provides a comprehensive analysis of the crisis covering both the domestic factors in the US and the global factors.
- A close second was Nouriel Roubini’s Crisis Economics. Roubini’s writings during the depths of the crisis were perhaps the most insightful discussions that one could get in real time. (I remember that Roubini was also the most insightful commentator on the Argentine crisis of 2001 in real time and next only to Krugman in real time analysis of the Asian Crisis in 1997-98). Perhaps it was because I read Roubini’s book with such high expectations that I found his book a little rushed. That pushed the book to second place in my ranking. Yet, I think that Roubini is also a book that anybody who wants an analytical understanding of the whole crisis must read.
Then there are books that provide important but partial theoretical perspectives on the crisis.
- Simon Johnson’s 13 Bankers is a wonderful book. We know a lot about emerging market crises because there have been so many of them; and Simon Johnson applies that knowledge to the crisis in the United States. The idea that the US has behaved like an third world country during the crisis is an important idea to which I am very sympathetic. I talked about Mahathirism in the US and UK in a blog post in April 2008. Yet I somehow found his May 2009 article The Quiet Coup in the Atlantic more powerful and satisfying than the book itself.
- Animal Spirits by George Akerlof and Robert Shiller, is a book length analysis of what Keynes discussed in a single paragraph in the General Theory. It appears to me that “Animal Spirits” needs more than a paragraph, but less than a book.
- Martin Wolf, Fixing Global Finance is a book that I liked very much, despite its heavy focus on global imbalances.
- Robert Shiller’s The Subprime Solution is a masterly analysis of the housing bubble by an economist who did warn about the bubble long before it burst. Similarly, Andrew Smithers’s Wall Street Revalued comes from an economist who made his name by warning about the dot com bubble.
- Are the Golden Years of Central Banking Over? by Stefan Gerlach and others deals at length with the monetary policy and financial regulation implications of the crisis. Richard Koo’s The Holy Grail of Macroeconomics about balance sheet recessions and the lessons from Japan is also an interesting book.
- Among the books in this genre that I read but did not enjoy to the same extent were ECONned by Yves Smith, How markets fail by John Cassidy, The origin of financial crises by George Cooper and POP: why bubbles are great for the economy by Daniel Gross.
The third category is books that provide a detailed factual narrative of the entire crisis.
- By far the best book here is the magnum opus by Andrew Sorkin – Too Big to Fail. He has been able to put together eye witness accounts from so many sources that the book makes it appear that Sorkin was a fly on the wall watching and listening as the momentous events unfolded.
- Another must read book is Henry Paulson’s On the Brink. Despite being written so soon after Paulson stepped down as Treasury Secretary, the book is surprisingly frank and detailed. He does seek to justify what he did, but manages to do so without becoming jarring. I am tempted to say that Paulson has done a far better job as an author than he did as Treasury Secretary.
- I am waiting eagerly for Bernanke’s long promised book Before Asia Opens. If Bernanke serves as Fed Chairman for as long as Greenspan did, we might have forgotten about the crisis by the time we get that book.
Another important category of crisis books look at specific actors or groups of actors that made or lost a fortune in the crisis.
- The Big Short by Michael Lewis and the Confidence Game by Christene Richard are among the most enjoyable crisis related books that I have read. (I have yet to read Gregory Zuckerman’s Greatest Trade Ever).
- William Cohan chronicles the demise of Bear Stearns in House of Cards, while Roger Lowenstein has a broader sweep covering Bear, Lehman, AIG and the rest of the infamous cast in his End of Wall Street. I believe however that no book on Lehman is likely to match the dull prose of the 2,200 page report produced by the court examiner Anton Valukas.
- Several great books about hedge funds, quants and nerds helped me understand the crisis much better though they are only partly (or in some cases, only peripherally) about the crisis. Sebastian Mullaby’s More Money than God, Scott Patterson’s The Quants, David Leinweber’s Nerds on Wall Street, and Richard Bookstaber’s Demon of Our Own Design are all books from which I learned a lot. They are also well written and immensely enjoyable. Lecturing Birds on Flying by Pablo Triana gives an extreme anti-quant view, but I found the book unconvincing. Gillian Tett’s fabulous book on the origin and growth of credit default swaps – Fool’s Gold – is another must read. Selling America Short by Richard Sauer is also a very good book; all regulators should definitely read this.
I now turn to official reports related to the crisis.
- On the crisis as a whole, the IMF’s Global Financial Stability Report, the BIS Quarterly Review and Annual Report were indispensable in making sense of the crisis as it unfolded. But if I ask myself which of these would one like to re-read years later, it would be the BIS Annual Report for 2007-08, particularly its first chapter, “The unsustainable has run its course”. The Financial Crisis Inquiry Commission in the US is due to submit its report at the end of the year, but expectations are rather muted about this.
- On individual firms, I have already mentioned the Valukas report on Lehman. The Shareholder Report on UBS’s writedowns, and the subsequent Transparency Report are good sources of information on UBS. The report of the Special Investigation Commission in Iceland provides detailed information about the failure of the big Icelandic banks. Some information is available about AIG in the reports of the Congressional Oversight Panel, but we still know too little about that company.
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.
Wed, 20 Oct 2010
- The flash crash happened towards the end of the day in the US when
Asia and Europe were both closed and therefore nothing happened in
those markets. The rest of the world has therefore been able to think
of this as America’s problem. Had this happened when other
markets were open, it would have been every body else’s problem.
Quite apart from that, I think the flash crash is a serious issue for regulators in all countries. Large market orders interacting with a thin order book can cause a flash crash in any market anywhere in the world.
- The crash happened on a relatively calm and benign day. Yes, there
were some protests in Greece, but that hardly counts as a crisis
situation. Things would have been much worse if the crash had happened
when a big bank was tottering or when a serious terrorist attack or a
grave natural calamity was in progress.
In this sense, the flash crash episode can even be regarded as a good thing to have happened. Without causing much damage, it provided a wake up call to regulators to analyze market designs and make them more robust. If we do not take corrective action, we will probably end up facing a much bigger market disturbance on a bad day.
It is a mistake to think that the flash crash can happen only with automated high frequency trading. With a sufficiently thin order book, a flash crash can be triggered by a cascade of stop loss orders (at one level, a stop loss order is also an algorithm). Indeed, even a cascade of market orders is sufficient.
- It is time to reconsider the whole issue of internalization that
allows brokers to execute proprietary trades against customer order
flow without routing everything to a transparent execution venue.
The SEC report discusses internalization at length, but its cognitive capture is so complete that it does not see anything wrong in what happened. What are the fiduciary responsibility of a market maker who thinks that the market is too risky to trade in on its own account but merrily routes customer orders into that same market? Is it acceptable to argue that this is fine because the trades would be cancelled anyway?
The CFTC/SEC report has not provided confidence to the retail investors about the integrity of the market structure. It has failed to provide a convincing and conclusive answer to whether any market abuses happened during the flash crash.
- There is need to examine whether the SEC’s implementation of
the National Market System is fundamentally flawed.
The technology underlying the dissemination of the National Best Bid and Offer (NBBO) is so antiquated compared to the rest of the modern market infrastructure that the professionals seem to be relying only on proprietary price feeds.
At the same time, as trading gets fragmented across multiple execution venues, the need for best execution is only becoming more and more pressing.
As trading has moved to ever shorter latencies, the surveillance capability of the regulators has fallen far behind. Regulators do not seem to have the capabilities to analyze high frequency data at all and I think this is a serious problem.
There is a major problem with the accuracy of time stamps of major market infrastructure providers. Today using GPS time synchronization and PTP instead of NTP, it is possible to achieve accuracy of a few microseconds, and regulators need to mandate this for systemically important entities.
- We should consider eliminating the ability of exchanges to cancel
wrong trades completely.
The SEC has moved to make the cancellation process a little more objective and transparent than before. But today’s information technology makes it possible to get rid of trade cancellation completely. If an objective algorithm exists to determine the trades to be cancelled, the same algorithm can be used to prevent those trades from happening at all. Unlike in a manual system, the reaction time of a computer can be fast enough to “cancel” the trade in real time by not matching the trade at all.
- The evidence seems to suggest that the market structure has become
so fragile that it is an accident waiting to happen. I am reminded of
the old nursery rhyme:
For want of a nail the shoe was lost.
For want of a shoe the horse was lost.
For want of a horse the rider was lost.
For want of a rider the battle was lost.
For want of a battle the kingdom was lost.
And all for the want of a horseshoe nail.
When this kind of a thing happens, the solution is not to go in search of the blacksmith who lost the nail (or the mutual fund that did a large futures trade), but to build more buffers and make the system more robust so that a few nails and horses can be lost without catastrophic consequences. Just as we stress test individual banks, it is also necessary to stress test the entire market structure.
The best way to do that is to build simulated computer models of the entire market structure including the most popular trading algorithms and then stress test the whole edifice.
Sat, 16 Oct 2010
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.
Sun, 03 Oct 2010
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:
- “One key lesson is that under stressed market conditions, the automated execution of a large sell order can trigger extreme price movements, especially if the automated execution algorithm does not take prices into account.” This is referring to a sell order by a mutual fund for 75,000 index futures contracts with a notional value of $4.1 billion that was executed with a target participation rate of 9%. Roughly speaking, this participation rate implies that in any time interval, the algorithm tries to execute a quantity equal to one-tenth of what other traders are executing in the aggregate. The discussion in the report is hopelessly vague about what happened, but it suggests that the crucial problems described in the next point below were triggered when the first 3,300 contracts had been sold. While the report explains at length that 75,000 was a truly large order, it is clear that 3,300 contracts ($180 million) is not an outlandishly large trade. Surely, there must have been episodes in the past of a few thousand contracts being sold very quickly and the report could have provided a comparison of what happened on May 6 with what happened on those dates. And if the problem was market stress, then understanding the nature of that stress is critical.
- “Moreover, the interaction between automated execution programs and algorithmic trading strategies can quickly erode liquidity and result in disorderly markets.” The claim is that the large order confused the high frequency traders (HFTs) who increased their trading volume, and this higher volume fooled the mutual fund’s algorithm into selling even faster. As far as I can see, this is pure speculation. I would have liked to see this phenomenon demonstrated using agent based models or some other sound methodology.
- “As the events of May 6 demonstrate, especially in times of significant volatility, high trading volume is not necessarily a reliable indicator of market liquidity.” This is referring to the fact that: “ Moreover, compared to the three days prior to May 6, there was an unusually high level of ‘hot potato’ trading volume – due to repeated buying and selling of contracts – among the HFTs, especially during the period between 2:41 p.m. and 2:45 p.m. Specifically, between 2:45:13 and 2:45:27, HFTs traded over 27,000 contracts, which accounted for about 49 percent of the total trading volume, while buying only about 200 additional contracts net.” However, no explanation at all is provided for this – if HFTs were desperately trying to pass around the hot potatoes that they had acquired minutes earlier, why were they buying 200 more hot potatoes?
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:
- I also found some of the graphs difficult to interpret. For example, the charts on the order book are colour coded relative to the mid-price of the stock. Since this price was falling dramatically, it is difficult to see what parts of the order book were actually being eliminated through order execution or order cancellation. That prices can fall to near zero only if the buy side of the order book is exhausted is a tautology. One wants to see how and when the buy orders were cancelled or got executed.
- Most of the reported data for individual stocks is at one minute intervals and some at fifteen minute intervals when other analysts have been looking at events on a millisecond time scale. At a one minute time scale, several things happen simultaneously – for example, prices fall and order books shrink – but it is difficult to see what happened first. Causality is hard, but is it too much to ask for at least the sequencing to be described accurately?
- The report suggests that the order books of ETFs had less depth far from the mid quote and this led to the disproportionate incidence of broken trades in them. However, in the first part of the report, it is shown that the ETF on the S&P 500 (known as SPY) performed better than the index future itself. This suggests that not all ETFs are similar in the fragility of their order book, and I would have liked to see some exploration of this issue.
In conclusion, the report leaves me disappointed as regards the three critical questions that I asked myself after reading the report:
- 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.
- 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.
- 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.”