Taking stock of flash crashes

 
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New York Stock Exchange

US stock markets were hit by a 'flash crash'. Photo: © Khaled Diab

By Robert Adler

Fancy a beer company with your pint? For a few painful minutes, the value of many major US companies hit zero. And computers may share the blame.

17 May 2010

On Thursday 6 May, for a few minutes, you could have bought a frothy Sam Adams plus a substantial interest in its maker, the Boston Beer Company, all for the price of a pint. Boston Beer stock, along with dozens of others on the major US stock exchanges, plummeted to zero, while the Dow Jones Industrial Average nosedived 700 points, all in a matter of minutes.

To the great relief of most traders and to anyone whose financial well-being is linked even indirectly to the stock market — and in today’s global economy that’s pretty much all of us — the market rebounded almost as quickly. Still, the wild ride left even seasoned traders in shock.

It’s hard to overstate how much value was at risk during this ten-minute event.  As just one example, Exelon, a utility worth about $30 billion at 2.49pm  was worth nothing three minutes later. It’s estimated that one trillion dollars of value evaporated during the ‘flash crash’. That’s three times what the US spends on public education per year, $300 billion more the US  government bailout of the banking system in 2008, and about equal to the current European package to rescue Greece.

The grab-your-airsick-bag crash and rebound was certainly an anomaly, but that’s not the same as saying that it was an error, in the sense that it was caused by some specific mistake or malfunction.

Economist and market analyst John Hussman points out that US stock markets have hit similar “air pockets” — in 1955, 1987 and 1999. Like the Thursday event, those episodes resulted in roughly ten percent losses. The big difference is that they played out over weeks rather than minutes.

Since the Thursday debacle there’s been no shortage of finger pointing.

Early speculation centered on a so-called “fat-fingered trade” as the trigger for the selloff. Instead of offering to sell a few million shares of Procter and Gamble, rumour had it that a trader mistakenly put up a few billion shares.  Lacking buyers, the stock tumbled, starting a panic that took the rest of the market down with it.

The theory got a lot of attention, but like the infamous weapons of mass destruction in Iraq, there’s no evidence for it.

The most recent theory is that as the market edged lower, a particular hedge fund placed a $7.5 million bet that the drop-off would continue, and the rest of the hedge funds followed suit. Do lemmings come to mind?

One suspect that most market gurus do agree on is high frequency trading.  Multiple firms now trade using high speed computers linked directly to the stock exchanges. These constantly analyse massive amounts of data and exploit fleeting opportunities by buying and sell huge quantities of stocks in milliseconds. Experts estimate that these automated agents now make from 60%-70% of all trades on US markets.

The dominance of these computerised agents goes a long way towards explaining what happened, and the absence of an identifiable trigger.

If there’s one thing we’ve learned about complex systems since chaos theory pioneer Edward Lorenz popularised the idea of the ‘butterfly effect’ in the 1960s, it’s that they are capable of amplifying the tiniest perturbation to virtually any scale. It takes just one last snowflake to unleash an avalanche.

The stock market is a classic example of a highly dynamic system driven by many independent but interacting agents. One state it’s capable of occupying— what system theorists call an attractor — is when the tug of war between buyers and sellers arrives efficiently at a stock’s current value. That’s the state that economists tell us is the market’s  raison d’etre.

It would be lovely if that were the only way the system functioned. Unfortunately, history shows that stock markets are also prone to huge bubbles, in which contagious enthusiasm drives the prices of most stocks well above their “true” value, and, as we’ve just seen, “air pockets”, in which contagious fear does the opposite.

This was bad enough when human traders were the ones calling the shots. Presumably they had some sense that a company valued at $30 billion one minute couldn’t really be worth zero a few minutes later. Their interaction led to booms and busts, but at least those had believable tops and bottoms and unfolded on a human time scale.

Over the years, the markets have instituted various fixes to try to avoid some of their worst flaws. After the global “Black Friday” market crash of 1987, the New York Stock Exchange, for example, put in place “circuit breakers” — trading curbs aimed at slowing panic selling in order to head off the kind of crash that we just saw.

Some market analysts are blaming the circuit breakers themselves for the Thursday meltdown. They suspect that when the NYSE circuit breakers clicked in, the effect was to shunt the flood of sell orders to other markets that were even less able to find buyers for them.

This circuit-breaker issue has gained traction. Six major exchanges have now agreed to strengthen and coordinate their circuit breakers. New rules are currently being negotiated and should be in place within a few weeks.

Those fixes may be good ideas, but they almost certainly are nothing but temporary patches. The system remains as complex, dynamic, and unpredictable as ever. It’s still shuttling hundreds of billions of dollars form buyers to sellers at inhuman speeds every day, impelled not just by humans vacillating between greed and fear, but increasingly by bloodless computerised agents impelled by abstruse algorithms.

It’s worth noting that there’s no “beta testing” for these patches. That makes us guinea pigs in a very high-stakes experiment.

Regulators and investors would like to believe that the proposed fixes will result in an efficient, reasonably stable market. I think it’s more realistic to view the market as something like a manic-depressive chef on speed— often brilliant, but capable of cooking up a disaster at any time.

Neither the recent high-speed collapse and rebound nor the current fix-it-on-the-fly patches inspire a great deal of confidence in the US stock market. Unfortunately, in this highly linked global era, we’re all flying on the same airplane. I suggest that we fasten our seatbelts and brace ourselves for a wild ride.

Published with the author’s permission. ©Robert Adler. All rights reserved.

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Huff and puff brought the economic house down

 
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By Christian Nielsen

How the Mr Bigs and their biglettes unwittingly (or not) brought down the world’s economies – and the hotly contested prize for ‘America’s worst investor’.

5 October 2009

Two stories in The Economist have more in common than perhaps the magazine intended. One, accusing the MBA factories of doing little to mend their habit of churning out ever-smarter greedy buggers. The other, announcing a Golden Raspberry-inspired prize for the worst small investor in the United States.

I’ll deal with the MBAs first. But before starting, I must confess to having a Belgian derivative of this certificate. It never did me any good, bar an excuse to stay in the country. But the Mr Bigs of MBAs – I’m talking about the likes of London Business School, Harvard Business School (HBS) and others on the yearly ‘best MBA’ courses list – deliver a cohort of big achievers year on year, at a not inconsiderable cost to the students or their organisations.

These Mr Bigs and their biglettes have done sweet f-all to mend their Gekko-esque educational model moulded round the mantra that “greed is good for everyone, especially me”.

The bankers have, at least in principle, been stripped of their pinstripes and, if France gets its way, their future fiduciary roar as well. But until I read this trumpeting repost by Schumpeter (‘The pedagogy of the privileged’), I hadn’t considered the degree of culpability that the elite education machine should perhaps also bear. He says these institutions of learning have been “churning out jargon-spewing economic vandals”, the likes that lined the executive tables of such feted organisations as Enron, Lehman Brothers and half of the Wall Street walkers now offering good CV and an ego-massage to anyone who‘ll now listen.

Yes, blueprints for betterment have been drawn up by some of these fine establishments, The Economist says, but little has emerged of note. No, wait, HBS has introduced a voluntary pledge “to serve the greater good” and a group of Harvard students have set up an oath of “responsible value creation”, according to BusinessWeek’s website.

(Makes you wonder  if that ‘greater good’ is of the kind you would hear espoused at a GOP rally: ‘make shit loads of profit and let the rest take care of itself’. Sound familiar?)

So, if the bankers are going to be made to pay – just a little, and even that isn’t a given because, like a mugging, as the economy starts to show signs of improving, it’s easier to forget the trauma – why not the manufacturers of the greed-is-good method of wealth creation?

Perhaps business schools could start teaching history as well, it was suggested, to remind graduates that the laws of gravity work for money markets too. Taking a knife to the climate of “boosterism” – puffing up the models and methods of certain businesses, people or consultancies – prevailing at some business schools was also put forward as an antidote to acolyte-building academia.

“Business schools need to make more room for people who are willing to bite the hands that feed them: to prick business bubbles, expose management fads and generally rough up the most feted managers,” Schumpeter concluded.

Perhaps we need a matrix to help explain this. Any bright MBA grads want to help us out with that?

Spurious connection

I’m going to make another confession; I didn’t really have a strong ’connector’ for this second story. It just sounded like a really fun idea to highlight: the folly of investment-envy and the slavish adherence to the sort of MBA-inspired confidence that drove people to think they were on to a winning investment strategy for ever.

With some careful analysis, you could probably make a fair case for one relating to the other, but I don’t have the smarts for that – my MBA was a bottom-shelf affair.

The deadline to apply for the ignominious title of ‘America’s worst investor’, the contest organised by Hedgeable.com, is 12 October. Don’t miss this train too! With no shortage of contenders, this is an admirable effort to poke the wounds of this year’s economic fiasco, and perhaps in doing so, remind us that even smart people can make some dumb decisions.

Read Reuters Blogs for some commentaries on how some small and medium-sized American hedge funds and asset managers got their clients (a lot of them retirees) in the hock with exotic derivatives.

Watch this space for expert commentary and sharp(ish) analysis on the winning losers.

Side note: Chronikler would be happy to publicise any effort to set up a ‘Europe’s worst investor’ prize. The Americans are offering the winners – I mean losers – trips to Rome, Las Vegas and Iceland, all home to decent collapse some time in the last 2000 years. Perhaps the European winners could win a trip to Wall Street or the City. Just a thought.

©Christian Nielsen. All rights reserved

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