Market Sentiment & Lateral Thoughts

from Neil Behrmann and other authors

Prevention of future financial collapse difficult

Alleged role of a single day trader in ‘flash crash’ suggests US and UK regulators are very late in the day

April 2015

ALLEGATIONS that a single UK day trader caused the “flash crash” five years ago indicate that regulators and central bankers will find it difficult to prevent a potential future global financial collapse.
Indeed, growing numbers of financial commentators, including the Bank for International Settlements (BIS), warn that quantitative easing (QE) of the US Federal Reserve, European Central Bank (ECB), Bank of England (BOE) and Bank of Japan (BOJ) have raised the risks of another major financial crash. Central bankers’ spin is that they are applying “macro-prudential regulation” to counter the risk of a systemic financial slump. Critics have their doubts.
“Advocates of ultra-low or negative interest rates argue that macro-prudential tools can be used to offset/mitigate the financial risks and distortions resulting from ultra-easy monetary policy,” says BIS deputy general manager Herve Hannoun. “Unfortunately, this is not a realistic approach. . . The policy of prolonged ultra-low, or negative, interest rates relies on transmission channels with uncertain effectiveness and potentially serious unintended consequences.”

Regulators Behind the Curve

Two disclosures last week illustrate that regulators have been behind the curve. First, Deutsche Bank was fined a record US$2.5 billion. The penalty raised to almost US$13 billion the fines of miscreant banks which were involved in the rigging of foreign-exchange rates and Libor (London interbank offered rate) – the key global interbank borrowing marker for US$350 trillion global debt.
Secondly, Navinder Singh Sarao, 36, was arrested in London on criminal charges that his trades led to the 2010 flash crash, when an estimated US$1 trillion was briefly wiped off the value of global stocks in a few minutes. He is one of the numerous individual traders outside the dealing arena of banks, brokers, pension and traditional and hedge fund managers.
These individuals aren’t within the ambit of compliance officers who apply strict risk limits within banks and are there to detect rogue traders. Some “day traders” rent space, computers and other facilities from firms and deal on their premises, others operate from home.
The US Commodity Futures Trading Commission (CFTC) and the US Department of Justice have charged Sarao with wire fraud, commodities fraud, commodities manipulation and “spoofing”, which carry prison sentences of between 10 and 25 years per count, or a fine of US$1 million or more. The authorities allege that Sarao’s alleged gains amounted to US$40 million between 2010 and 2014, including US$879,000 on the day of the flash crash.
(“Spoofing” can be likened to bluffing in a poker game: The trader places big buy or sell orders for bonds, shares or derivatives. The aim is to get other market participants to believe that prices are heading up, or down. Within seconds, the spoofer’s trading programme cancels the orders and places opposite deals to profit from the sales and purchases of other traders.)

High Frequency Trading another menace

Sarao, who has been dealing from his home in Hounslow, near London Heathrow Airport, is fighting extradition and has been granted £5 million (S$10 million) bail in London. In an email to the Financial Conduct Authority last year, he had claimed that all his trading “is done with my hand and a mouse”, Reuters reported.
He said that he “changes his mind very quickly”, which is “unique about my trading, I trade very large but change my mind in a second”. He had also claimed that his programme aimed to disguise his orders in order to outwit “front running” high-frequency traders (HFTs). HFTs – hedge funds and others – have been widely criticised. Their programmes, with computers linked to exchanges, are so fast that they obtain better prices than disgruntled institutions and other investors.
Regardless of whether Sarao is extradited and found guilty or innocent, US and UK regulators appear to be very late in the day.
Comments author Michael Lewis who has written a book on HFT: “The first question that arises from the Commodity Futures Trading Commission’s case against Navinder Singh Sarao is: Why did it take them five years to bring it? A guy living with his parents next to London’s Heathrow Airport (allegedly) enters a lot of big, phony orders to sell US stock market futures; the market promptly collapses on May 6, 2010; it takes five years for the army of US financial regulators to work out that there might be some connection between the two events. It makes no sense.”

QE ultimately to blame and “Butterfly Effect”

The worrying aspect is that an amateur dealer operating on a remote island could legally, or illegally, precipitate the “butterfly effect” that first leads to selling, multiplied orders, panic and crash. A large proportion of day traders deal in the mammoth derivatives market which has grown to a mind-boggling size. The BIS estimates that notional value of exchange-traded derivatives amounted to US$27.2 trillion as at June 2014, while the value of over-the-counter derivatives was US$691.5 trillion.
Hardly surprising, BIS officials, economists and experienced market participants are disturbed. They fear that the Fed and others’ QE, zero and negative rates have encouraged investors, large and small, to take greater risks in markets which are already sky-high.
BIS’s current and former officials regard QE as a dangerous monetary experiment. Instead of it being a moral, disciplined example to the markets, central banks themselves have become speculators. The latest example is the ECB and Eurozone central bank purchases of highly priced bonds with yields close to zero or negative, or have a poor credit rating. In the past couple of years, Fed policies were a major factor in causing a flood of money into Asia and other emerging markets.
The eventual result some two years ago were sharp stock and bond setbacks accompanied by a slide in currencies and decline in economic growth. Moreover, there is a recent case study, already. Excessive Fed, ECB and BOE ease following the 2000 tech stock crash, 9/11 and recession ultimately caused the property, sub-prime mortgage debt, stock and commodity bubble that went bust in 2008 to 2009.
Rogue traders and other financial criminals multiplied in the previous boom, notably Bernard Madoff, former chairman of Nasdaq.

copyright Neil Behrmann

Neil Behrmann is author of Trader Jack- The Story of Jack Miner and anti-war children’s novel Butterfly Battle- The Story of the Great Insect War
Signed copies can be obtained directly from http://www.thestoryofjackminer.com/?page_id=14
and Butterfly Battle at http://www.readmore-books.com/
If the books are purchased direct, a proportion of the proceeds will go to low cost charities

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