The Day the Market Stands Still

Several years ago Warren Buffet proclaimed derivatives to be akin to ‘financial weapons of destruction’ – if only he knew the half of it. True that derivatives are opaque, illiquid, and often exotic.  Their very nature is both inherent to the way we do business and to the fear of how business is done today.  However, May 6th may point to a much more dire concern – how fragile is our market structure, really?

On the day of the Flash Crash one of my thoughts, on a day when most of us barely had time for a few, was that we had just seen a terrorist event.  Maybe it was (I’ve been told it wasn’t), maybe it wasn’t but, whether we like or not we were clearly exposed.   For the purposes of this discussion we will make an assumption; either May 6th was a planned mini-attack (let’s call it an incursion), or it wasn’t (a completely random perfect storm) – it cannot be both.  Either way one fact remains, certain vulnerabilities in the way business is done have been exposed.  Their have been advancements since the Flash Crash, particularly the single-stock circuit breaker that holds trading when an individual stock moves more than 10%  within 5 minutes.  Lack of uniformity was placed as the chief cause of the wild events that day, and ‘slowed’ trading on the NYSE was credited with lessening the damage. What has been exposed here is at the core of our financial system; our markets ability to operate and do so electronically, to provide liquidity regularly, are integral to our economy.  Detailed information of tick-by-tick information, not just of trades, but true market depth, called market-latency information is used, among other things, to decipher market activity and to improve quantitative models.  This information is available to anyone who can pay for it (namely hedge funds) and may most certainly be used to exploit the weaknesses of our system, but one integral ingredient is missing.

Why is that terrorists are often so difficult to overcome?  It is nearly impossible to defeat an adversary who is willing to take his/her own life; they are willing to inflict a kind of damage that no one who possesses the instinct of preservation can conquer – people willing to die to kill you are tough to beat; people with money to burn are similarly dangerous.  The markets would prove a devastating parallel to that conundrum.  Is an efficient market prepared for extremely large participants (by sheer size, or by derivative leverage) that do not care if they lose?  The market is supposed to be a zero-sum game, but I am reminded of a Keynes quote, “If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours.” From ‘Long-Term Capital Management’ through AIG and Citigroup, that principal has been reinforced – be careful who owes you how much money.  What if someone deliberately created a LTCM, a ever-expanding web of leveraged bets upon leveraged bets, designed not to be bailed out (or to be bailed out, whichever you prefer)?  This is my point.

Now allow us to bifurcate.  We have two separate, yet not necessarily distinct issues; one is that, whether intentionally or not, our system has been tested and we can expect future tests, and two is that we don’t know how a market with a LTCM designed to disrupt the market would behave.  Either, in and of themselves, are completely terrifying.  What I suspect, however, is that the two need to be thought of as more intertwined, in the sense that derivatives are designed to be whatever they are designed to be – little else.  I am not saying that derivatives would be how a hypothetical financial cyber attack might be packaged.  What I am saying is that given the derivative exposure borne by the market today, that if and when such an attack were to occur it would be devastating.  An attack sever enough to close US markets for “an extended period” (as Doug Kass recently suggested) could bring renewed strain to global, and particularly US and European, markets still weak from recession.

In the absence of significant changes to market structure, and without addressing the portion of market activity comprised by automated trading, their remains reasonably high-risk in any short-run period due to market structure and possible liquidity crisis’.  With the leverage available on the futures and options offered on the myriad of financial products available today it becomes more than plausible that a, or a group of, participant(s), that may or may not care about preserving capital (they may be using capital as a weapon), could deliberately and effectively disrupt our entire market structure.  Moreover, if one combines the principles of what I’ve discussed with a breach in security, a cyber ‘hack’ if you will, they would likely discover an equally chilling prospect.

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