It’s the financial service web site FierceFinance.com who have put together the list of the biggest blunders in the industry during the past year. Personally, I might have put a few other issues on the list, but when it comes to the final top position I think we have a winner:
Yeah, losing $600 million is probably harder than earning them, and quite an achievement…
“The MF Global failure was a total unraveling involving poor management and risky investment. For what it’s worth, Corzine said he will not be seeking to collect his $12 million Golden Parachuteseverance package. But reports surfaced in The Telegraph speculating that MF Global employees in the U.K. may have received Q3 corporate bonuses, even with the firm on the brink of failure.”
“The backlash against the bank was severe. But CEO Brian Moynihan defended the bank’s right to make a profit, saying in a statement that he had “an inherent duty as a CEO of a publicly owned company to get a return for my shareholders.”
3. Frustration sparks Occupy Wall Street protests.
“What originated as peaceful has become violent, as reports surfaced of police using tear gas on protestors along with attempts to force them out of encampments.”
“Even though S&P went on to be criticized for its debt rating practices (the issue of credit rating agency credibility looms large), the move was significant at a time when budget showdowns in Washington and a stagnant economy were constantly in the headlines.”
5. Raj Rajaratnam slammed for insider trading.
“The convicted insider trader dominated the news in 2011 and in many ways is seen as the pinnacle of success for federal prosecutors, who have been cracking down on offenders.”
6. Citi stumbles after major data breach.
“Citi was reluctant to publicly announce the breach, finally doing so only after being pressed on the subject by the media. Citi offered a public explanation of the incident and tried reassuring customers that the stolen data was insufficient to commit fraud and that social security numbers, dates of birth and card security codes remained secure.”
7. Bank of America forecloses on couple.
“One of the more bizarre stories of 2011 was when Bank of America accidentally foreclosed on a Florida couple. Although the bank eventually backed down, the couple hired a lawyer to recoup attorney’s fees. Five months passed without payment–this coming after a judge ordered the bank to pay up. So the couple and its attorney showed up to foreclose on a local Bank of America branch, declaring their intent to remove furniture, cash and other property.”
8. RSA suffers cyber attack.
“RSA’s SecureID tokens are used by 30,000 organizations worldwide. RSA remained open about the attack, offering tips and posting details describing the anatomy of the breach. But even transparency didn’t reverse the fact that banks were forced to rethink security and look for new options.”
9. Typo costs Goldman Sachs $45 million.
“A tip for everyone who deals with contracts: Double check all calculations. Goldman Sachs learned that lesson the hard way back in June when it issued four warrants relating to Japan’s Nikkei index. Buried in the depths of financial jargon was a serious formulaic mistake: A multiplication sign was inserted where there should have been a divide by sign.”
“In all likelihood, 2011 will not be a great year for hedge fund manager John Paulson. Among his failures was selling 35 million shares of the Chinese company Sino-Forest at an estimated loss of $500 million.”
“In summary, our analysis of trades broken on May 6 reveals they were concentrated primarily among a few market participants. A significant number of those trades were driven by sell orders from retail customers sent to internalizers for immediate execution at then-current market prices,” the US Commodity Futures Trading Commission and the US Securities and Exchange Commission concludes in their just released report on the so-called “flash crash” on May 6th this year. And they seem to have found a scapegoat:
“At 2:32 p.m., against this backdrop of unusually high volatility and thinning liquidity, a large fundamental trader initiated a sell program to sell a total of 75,000 E-Mini contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position.”
US Commodity Futures Trading Commission – US Securities and Exchange Commission
“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. The execution of this sell program resulted in the largest net change in daily position of any trader in the E-Mini since the beginning of the year,” the report says.
The “large fundamental trader” have been identified as the 73 years old investment firm Waddell & Reed.
“Only two single-day sell programs of equal or larger size – one of which was by the same large fundamental trader – were executed in the E-Mini in the 12 months prior to May 6. When executing the previous sell program, this large fundamental trader utilized a combination of manual trading entered over the course of a day and several automated execution algorithms which took into account price, time, and volume. On that occasion it took more than 5 hours for this large trader to execute the first 75,000 contracts of a large sell program,” SEC and CFTC notes.
Adding: “However, on May 6, when markets were already under stress, the Sell Algorithm chosen by the large trader to only target trading volume, and neither price nor time, executed the sell program extremely rapidly in just 20 minutes. “
According to the report, the sell pressure was initially absorbed by:
1. High frequency traders (“HFTs”) and other intermediaries8 in the futures market;
2. Fundamental buyers in the futures market; and
3. Cross-market arbitrageurs9 who transferred this sell pressure to the equities markets by opportunistically buying E-Mini contracts and simultaneously selling products like SPY, or selling individual equities in the S&P 500 Index.
“HFTs and intermediaries were the likely buyers of the initial batch of orders submitted by the Sell Algorithm, and, as a result, these buyers built up temporary long positions. Specifically, HFTs accumulated a net long position of about 3,300 contracts. However, between 2:41 p.m. and 2:44 p.m., HFTs aggressively sold about 2,000 E-Mini contracts in order to reduce their temporary long positions. At the same time, HFTs traded nearly 140,000 E-Mini contracts or over 33% of the total trading volume. This is consistent with the HFTs’ typical practice of trading a very large number of contracts, but not accumulating an aggregate inventory beyond three to four thousand contracts in either direction.”
“The Sell Algorithm used by the large trader responded to the increased volume by increasing the rate at which it was feeding the orders into the market, even though orders that it already sent to the market were arguably not yet fully absorbed by fundamental buyers or cross-market arbitrageurs. In fact, especially in times of significant volatility, high trading volume is not necessarily a reliable indicator of market liquidity.”
What happened next is best described in terms of two liquidity crises, the report says.
A Double Squeeze
“The combined selling pressure from the Sell Algorithm, HFTs and other traders drove the price of the E-Mini down approximately 3% in just four minutes from the beginning of 2:41 p.m. through the end of 2:44 p.m. During this same time cross-market arbitrageurs who did buy the E-Mini, simultaneously sold equivalent amounts in the equities markets, driving the price of SPY also down approximately 3%,” the regulators write.
“Still lacking sufficient demand from fundamental buyers or cross-market arbitrageurs, HFTs began to quickly buy and then resell contracts to each other – generating a “hot-potato” volume effect as the same positions were rapidly passed back and forth. 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.”
At this time, buy-side market depth in the E-Mini fell to about $58 million, less than 1% of its depth from that morning’s level. As liquidity vanished, the price of the E-Mini dropped by an additional 1.7% in just these 15 seconds, to reach its intraday low of 1056.
“This sudden decline in both price and liquidity may be symptomatic of the notion that prices were moving so fast, fundamental buyers and cross-market arbitrageurs were either unable or unwilling to supply enough buy-side liquidity,” the report explains.
In the four-and-one-half minutes from 2:41 p.m. through 2:45:27 p.m., prices of the E-Mini had fallen by more than 5% and prices of SPY suffered a decline of over 6%.
“The second liquidity crisis occurred in the equities markets at about 2:45 p.m. Based on interviews with a variety of large market participants, automated trading systems used by many liquidity providers temporarily paused in reaction to the sudden price declines observed during the first liquidity crisis. These built-in pauses are designed to prevent automated systems from trading when prices move beyond pre-defined thresholds in order to allow traders and risk managers to fully assess market conditions before trading is resumed,” the report says.
A Flash Back
Okay, before I continue, let’s relive the historical – and totally crazy – 20 minutes on the afternoon of May 6th. (Cut down to 10) as the old saying that “pictures are best on radio” once again proves its infinity:
A Triple Dose
According to the US regulators, there’s also three important lessons to be learned from the May 6th event.
#1. “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. Moreover, the interaction between automated execution programs and algorithmic trading strategies can quickly erode liquidity and result in disorderly markets. 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.”
#2. “May 6 was also an important reminder of the inter-connectedness of our derivatives and securities markets, particularly with respect to index products. The nature of the cross-market trading activity described above was confirmed by extensive interviews with market participants (discussed more fully herein), many of whom are active in both the futures and cash markets in the ordinary course, particularly with respect to “price discovery” products such as the E-Mini and SPY.”
#3. “Another key lesson from May 6 is that many market participants employ their own versions of a trading pause – either generally or in particular products – based on different combinations of market signals. While the withdrawal of a single participant may not significantly impact the entire market, a liquidity crisis can develop if many market participants withdraw at the same time. This, in turn, can lead to the breakdown of a fair and orderly price-discovery process, and in the extreme case trades can be executed at stub-quotes used by market makers to fulfill their continuous two-sided quoting obligations.”
The regulators have conducted a series of interviews with market participants involved in the May 6th flash crash.
According to the interviews, almost everyone says they use a combination of automated algorithms and human traders to oversee their operations.
As such, data integrity was cited by the firms we interviewed as their number one concern, the report points out.
“To protect against trading on erroneous data, firms implement automated stops that are triggered when the data received appears questionable.”
“One way of identifying potentially erroneous data is to screen for large, rapid price moves. For example, it was reported that the rapid decline in prices of the E-Mini, starting around 2:40 p.m. triggered data-integrity pauses in trading across a number of automated algorithms. Rapid declines in individual securities also contributed to data-integrity concerns and triggered trading pauses. Collectively we refer to these as “price-driven integrity pauses.”
“It is important to note these types of pauses are not necessarily the result of erroneous price data, but instead are based on prudential checks into the possibility that large, observed price changes are the by-product of a system error. In fact, the large price declines simultaneously observed across securities and the E-Mini contract during the afternoon of May 6 were indeed real.”
Very High – Very Low
The high frequency trading have been suspected as a possible cause of the flash crash.
However, the SEC/CFCT report can’t confirm or dismiss the accusations.
“Of the HFTs we interviewed, we did not find uniformity in response to market conditions on May 6. Although some HFTs exited the market for reasons similar to other market participants, such as the triggering of their internal risk parameters due to rapid price moves and subsequent data-integrity concerns, other HFTs continued to trade actively. Among those HFTs that continued to trade, motivations varied, but were in part based on whether they thought their algorithms would be able to operate successfully (profitably) under the extreme market conditions observed that afternoon.”
“In summary, our analysis of trades broken on May 6 reveals they were concentrated primarily among a few market participants. A significant number of those trades were driven by sell orders from retail customers sent to internalizers for immediate execution at then-current market prices. Internalizers, in turn, routed these orders to the public exchanges for execution at the NBBO. However, for those securities in which market makers had withdrawn their liquidity, there was insufficient buy interest, and many trades were executed at very low (and sometimes very high) prices, including stub quotes.”
I guess the econotwisted way to sum this up will be:
On May 5th 2010 all the money in the US stock market disappeared for some reason – and after about 20 minutes they suddenly came back, for some reason….
Appearing before the US Senate Banking Committee Thursday, FED chairman Ben Bernanke began his testimony on the recently approved US legal overhaul – the regulation of the financial system. In a prepared speech, Bernanke praised the Dodd- Frank Act for addressing critical regulatory gaps that were revealed by the financial crisis, pointed out that the Federal Reserve was working closely with other regulators to enact the law that was approved by Congress in July. The chairman also introduced “quantitative surveillance” of the US banking system. Read the full transcript of Mr. Bernanke’s testimony.
“The stress tests also showed how much the supervision of systemically important institutions can benefit from simultaneous horizontal evaluations of the practices and portfolios of a number of individual firms and from employment of robust quantitative assessment tools.”
“As it was put by my former colleague, Markus Brunnermeier, a scholar affiliated with the Bendheim center who has done important research on bubbles; we do not have many convincing models that explain when and why bubbles start. I would add that we also don’t know very much about how bubbles stop either.”
The FED chief thanked the Senate for confirming two of three outstanding Federal Reserve Board governor nominees , filling key slots on the central bank’s board.
Bernanke will over the next days participate in a panel taking questions from Senators on implementation of the latest financial overhaul. The panel also includes Sheila Bair, head of the Federal Deposit Insurance, Mary Schapiro, head of the Securities and Exchange Commission and Gary Gensler, head of the Commodity Futures Trading Commission.
Ben Bernanke started his opening statement by saying:
“In the years leading up to the recent financial crisis, the global regulatory framework did not effectively keep pace with the profound changes in the financial system. The Dodd-Frank Act addresses critical gaps and weaknesses of the US regulatory framework, many of which were revealed by the crisis. The Federal Reserve is committed to working with the other financial regulatory agencies to effectively implement and execute the act, while also developing complementary improvements to the financial regulatory framework.”
“The act gives the Federal Reserve several crucial new responsibilities. These responsibilities include being part of the new Financial Stability Oversight Council, supervision of nonbank financial firms that are designated as systemically important by the council, supervision of thrift holding companies, and the development of enhanced prudential standards for large bank holding companies and systemically important nonbank financial firms designated by the council, including capital, liquidity, stress test, and living will requirements.”
“In addition, the Federal Reserve has or shares important rulemaking authority for implementing the so-called Volcker Rule restrictions on proprietary trading and private fund activities of banking firms, credit risk retention requirements for securitizations, and restrictions on interchange fees for debit cards, among other provisions,” he said.
Introducing QS 1
According to Mr. Bernanke, a critical feature of a successful systemic or macroprudential approach to supervision is a “multidisciplinary perspective.”
“Our experience in 2009 with the Supervisory Capital Assessment Program – popularly known as the bank stress tests – demonstrated the feasibility and benefits of employing such a perspective. The stress tests also showed how much the supervision of systemically important institutions can benefit from simultaneous horizontal evaluations of the practices and portfolios of a number of individual firms and from employment of robust quantitative assessment tools,” he told the senators.
“Building on that experience, we have reoriented our supervision of the largest, most complex banking firms to include a quantitative surveillance mechanism and to make greater use of the broad range of skills of the Federal Reserve staff,” he said.
The policy, based on the economic theories of John Maynard Keynes, means in practice to pour money into the the financial system in numerous ways to stimulate economic growth in times of contraction.
Many economists, commentators and other financial experts have started to question the theories, used by both central banks and governments to build their arguments and actions.
After spending unknown trillions of dollar to counter the economic downturn, without much visible results, it’s quite understandable.
However, Ben Bernanke, will defend the FED’s policy with the strongest conviction.
Speaking at a conference at Princeton last Friday, he said:
“Standard macroeconomic models, such as the workhorse new-Keynesian model, did not predict the crisis, nor did they incorporate very easily the effects of financial instability. Do these failures of standard macroeconomic models mean that they are irrelevant or at least significantly flawed? I think the answer is a qualified no.”
“Economic models are useful only in the context for which they are designed. Most of the time, including during recessions, serious financial instability is not an issue. The standard models were designed for these non-crisis periods, and they have proven quite useful in that context. Notably, they were part of the intellectual framework that helped deliver low inflation and macroeconomic stability in most industrial countries during the two decades that began in the mid-1980’s,” Ben Bernanke said at the conference, sponsored by Center for Economic Policy Studies and the Bendheim Center for Finance.
PS: Don’t Blame The Models
On the other hand, human behavior is still a big problem.
Or as the FED chief puts it: “Most economic researchers continue to work within the classical paradigm that assumes rational, self-interested behavior and the maximization of “expected utility” – a framework based on a formal description of risky situations and a theory of individual choice that has been very useful through its integration of economics, statistics, and decision theory.9 An important assumption of that framework is that, in making decisions under uncertainty, economic agents can assign meaningful probabilities to alternative outcomes. However, during the worst phase of the financial crisis, many economic actors – including investors, employers, and consumers – metaphorically threw up their hands and admitted that, given the extreme and, in some ways, unprecedented nature of the crisis, they did not know what they did not know.”
The idea that at in certain times, decisionmakers simply cannot assign meaningful probabilities to alternative outcomes – even not think of all the possible outcomes – is known as Knightian uncertainty, after the economist Frank Knight who discussed the theory in the 1920’s.
“Research in this area could aid our understanding of crises and other extreme situations. I suspect that progress will require careful empirical research with attention to psychological as well as economic factors,” Bernanke replies.
Another issue that clearly needs more attention is the formation and propagation of asset price bubbles, the FED chairman acnowledge.
“Much of the literature at this point addresses how bubbles persist and expand in circumstances where we would generally think they should not, such as when all agents know of the existence of a bubble or when sophisticated arbitrageurs operate in a market. As it was put by my former colleague, Markus Brunnermeier, a scholar affiliated with the Bendheim center who has done important research on bubbles, “We do not have many convincing models that explain when and why bubbles start.” I would add that we also don’t know very much about how bubbles stop either.”
“The financial crisis did not discredit the usefulness of economic research and analysis by any means; indeed, both older and more recent ideas drawn from economic research have proved invaluable to policymakers attempting to diagnose and respond to the financial crisis. However, the crisis has raised some important questions that are already occupying researchers and should continue to do so. As I have discussed today, more work is needed on the behavior of economic agents in times of profound uncertainty; on asset price bubbles and the determinants of market liquidity; and on the implications of financial factors, including financial instability, for macroeconomics and monetary policy,” Ben Bernanke concludes.
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