Thursday, May 6, 2010

The good news is the IMF Money Train has arrived at Athens Central Station...

OK, that had to be one of the craziest days in the markets ever. So much was going on I almost don’t know where to begin.


Think of it this way. The governments of Europe, the European Central Bank and the IMF are acting out a drama in front of three separate audiences who are responsible for judging them and who communicate with each other through price signals. These audiences are the foreign exchange, credit and equity markets. Generally a credit trader will trade only credit and or an equity trader will trade only equity so the markets have different personalities.

Generally the credit markets tend to be filled with more analytical long term thinkers than equity markets do because its’ easier to change your mind in equities. Foreign exchange is dominated by people who are actually moving money around for a commercial purpose: trade, cross border investment, that sort of thing as opposed to credit and equity markets which are investments in their own right. The foreign exchange market is by far the largest and followed by credit followed by equity.


The drama as that is being played out is how the Eurozone is going to cope with the massive fiscal deficits of the countries on its southern rim. Today there were several acts in that drama. The European Central Bank held a meeting. Spain held a bond auction. Greece voted on the austerity package.

The ECB kept rates unchanged but some people thought that they might consider some kind of monetary easing either through a cut in the rate or some kind of quantitative easing such as the Federal Reserve has done in the US. The ECB announcement and the remarks of the Chairman said the topic was not even discussed. I think their objective was to show the world that they are confident that the IMF package will work so they are not considering drastic action. There are quite a few market participants who are deeply sceptical of the efficacy of the IMF package and have thier eyes on Greece and Spain, those people were disappointed with the ECB.

The Spanish bond auction went well I thought. They had to pay a higher rate for their bonds than they did the last time they went to the market but their credit has been downgraded since then and they did have an auction the day after the riots in Greece so I think this is understandable. The bid to cover ratio, or the ratio of amount of buyers relative to the amount of bonds for sale was 2.5 to one the highest in years meaning that there was a lot of demand at that higher rate so it would seem that Spain is not in the same position as Greece.

Finally, after a day of riots the Greek parliament voted on the austerity package. The Prime Minister and the Finance minister gave impassioned speeches about the need for unity. The opposition laughed. There are 300 members of the Greek parliament of whom 160 were members of the ruling Socialist party. In the end 172 members voted for the measure and three of the Socialists turned in blank ballots and were promptly expelled from the party. In any case, the motion carried.

This vote was significant because the opposition, by voting against it can score points when the austerity begins to bite safe in the knowledge that no one will know what would have happened had they won, which is that instead of people taking 20% pay cuts the government would have stopped functioning altogether. This is great domestic politics but pretty terrible international finance. Because now if you are a potential Greek bondholder you know that almost half the government has no skin in the game with regard to actually carrying out the austerity program. Greece already has credibility issues this did not help.


So how did the markets take the news. Well, at first the credit markets took it OK. They had really given the European governments a beating yesterday while the Greek riots were in full swing but once the Spanish got their bond auction off with a big bid to cover the credit markets tightened. The equity markets liked this even more and bounced into positive territory early in the morning before trading off on the fear that perhaps the Greeks would not pull off a win for the austerity program. When the Greeks approved the plan, equities had a brief bounce.

The FX markets however called bulls**t all day long. They slowly ground lower with each new news item. Keep in mind that the FX markets trade $3 trillion of value a day and people in the markets have been using dollar/euro as a proxy for the general perception of the success that policymakers are having with their efforts. The FX markets gave it a thumbs down and then the credit markets joined in. CDS markets for Spain and Portugal began to widen out. This is bad news for Portugal because they have to go to the markets to roll some debt that matures at the end of May. If they get that done they don’t have to do any more refunding until 2011 but you only need one auction to go wrong before its lights out.


The equity markets soon enough began to sell off after watching the FX and the credit markets booing and hissing the powers that be in Europe. There was a selloff into the European close, then a little rally once the Americans were on their own. The view in the US thus far has been that this is a European problem, that Greece is small and we don’t really have to worry about it. European markets have wiped out all the gains from 2010 in the past few weeks on the back of the Greece problems and America has outperformed. Not today.

Today the markets began to think that perhaps all this credit trouble in Europe might tighten credit markets generally and smother the nascent American recovery in the crib. I think that American equity markets are probably the least well informed of the triumvirate as to what is going on in Europe but they could not ignore the Euro, the CDS for Spain and Portugal and the fact that the European equity markets have traded a lot lower than the US has. So they began to sell, and sell hard. Then something interesting and deeply disturbing happened.


A lot of people when they think of the stock market in the US think of those scenes from the movie Wall Street with a bunch of guys gathered around a specialist hollering buy and sell. That image is as close to today’s reality as tin cans and a string are to the internet.

In the US the equity market is made up of both the famous stock exchanges of which you have heard and several dozen ECNs or electronic crossing networks. The old line exchanges have market makers or specialists who are responsible for making a continuous two sided price all day long. These guys generally and specialists in particular long abused their advantageous market position to shave cash off of most market participants. Believe me. I know.

People got so fed up with the specialist system people came up with all kinds of alternative trading venues called ECNs. These ECNs had all kinds of rules, fee structures, or special features to entice market participants to trade on them and pay the owners a transaction fee. These venues have proliferated and have fragmented the market to some extent. The government tried to link them up with a rule called Reg NMS but has so far had mixed results.

Another interesting feature of modern stock markets is the role of high frequency traders. These are automated trading systems whose orders to buy and sell are generated electronically using a formula and which hold positions for extremely short periods of time. These types of firms have been slowly displacing the specialists and the market makers as the primary liquidity providers to the marketplace. The key difference between a market maker and a High Frequency Trader is that a market maker or specialist has an obligation to maintain a two sided quote subject to certain conditions while a HFT firm does not, they are pursuing an opportunistic strategy which contributes liquidity as a side effect.

As the markets came apart today it looks like some of the HFT guys contributing liquidity may have backed away from adding their liquidity to the system. Some trading algorithms which were written with certain liquidity assumptions sent market sell orders into the market and overwhelmed what bids there were. This had the effect of pushing the prices of some stocks on some ECNs to a penny a share. These orders should have been routed to an exchange where there was a bid but for some reason this didn’t happen.

Now most people don’t have the ability to watch all 14,000 listed stocks in the US so they watch indexes as a proxy the most notable ones are the Dow Jones, the S&P 500 and the NASDAQ. The indexes themselves are calculated by machines which take the prices of trades in the component stocks, add them up, divide by a divisor and publish the index. If you have a few stocks in which some trades are all of a sudden executed near zero, the index seems to have fallen quite a lot and that’s what happened this afternoon.

Once the zero prints went up in a few stocks artificially creating lower prices in indexes people could not tell just by looking at the indexes that there were erroneous trades being used in their calculation, they thought that there was a massive panic. And then they themselves panicked. Also computer programs designed to limit losses if indexes or shares decline to a certain point also kicked in and the markets completely fell out of bed.

It's actually hard to exaggerate just how much they fell out of bed. It was the largest point decline in the history of the market and the largest percentage decline since 1987 which was the all time record holder by miles. And the whole thing happened in less than 10 minutes and was over just as fast. Granted we recovered quickly and well but you can tell that there are a lot of very nervous people out there. It would seem there are also some very nervous computers out there as well.

There is a lot going on in the world, and you don't have to go far to find reasons to panic, but it was exacerbated massively by the fractured market structure of the US equity markets. Rest assured, Congress will address itself to this issue.

Oh Boy. And the casino opens again tomorrow at 9:30AM...


London Banker said...

That is the single most cogent and informative description of Thursday's events I am ever likely to read. Well done!

Only thing I would point out is that less than 2 percent of the FX market relates to trade or commercial demand, with the rest being speculative and financial-engineering related (e.g., cover trade).

What this means for the next few weeks is huge disruption in FX, as virtually all OTC derivatives have to be margined in US dollar measures of credit support. The margin calls have gone out, the assets globally have devalued, therefore there is going to be a huge dollar squeeze. Central banks will have to have dollar swaps again, just like in 2008, to allow their banks to avoid default. Ugly.

At some point, we are going to have to ask ourselves as a society whether streaming 20+ percent of all corporate profits to Wall Street is a sustainable economic model. The sheer scale of Wall Street, along with the bonus culture, incentivises Wall Street to look around the global economy, find any profitable business or well run pension or municipality, and target them for stripping of all possible loose cash. The consequences for the 99.9 percent of the citizens who don't work on Wall Street are not going to be pretty.

Anonymous said...

Here is another angle

The Greeks have been playing naughty war games with other people's money

A major part of the Greek debt crisis is the result of excessive military expenditures forced on the country by the German military industrial complex. Greece has purchased more than 1,000 German Leopard tanks, but for half of them there are no shells. In addition, the Greek government bought three German submarines; two barely made it to Athens and the third is still in a German dockyard because it is not seaworthy.

Why did Greece buy such useless military hardware? Two reasons: That was the price Greece had to pay to secure German loans and EU grants and the Germans have had few qualms about bribing Greek politicians (remember the Siemens scandal?) to grease the wheels of industry. In 2009, 4.3 per cent of the Greek GDP went to military spending. Beyond purchasing faulty German military equipment, Greece sustains a large military establishment to counter continuing threats from Turkey, which accounts for a staggering $14.5 billion a year.

Ken said...

@ London banker, thanks a lot for the compliment. It's nice to hear that people appreciate the writing. I guess my experience of FX was as a summer intern on the FX options floor of the CME in Chicago. I guess we get a different picture down there. I think you're right that the Fed will bring back the dollar swaps though I think they'll not be as much help as one would like because the dodgy assets that need funding are all Euro denominated.

@anonymous. I'm not sure I agree with your specific theory but there is no question that malfeasance on the part of people in government in Greece had a big part to play in this.