A Normal Correction: February 27 Market Break April 23, 2007
A Normal Correction: February 27th Market Break
"For the market's getting creamed is a healthy thing. It shakes out the froth (that's you they're talking about) and sets the stage for another, bigger and stronger dash upward. So goes the post-meltdown mantra of the chronic bulls."
On Tuesday, 02/2707, a 9% drop in
the Shanghai market triggered a messy global sell-off, all this following a grim economic pronouncement by former Fed Chairman Alan
Greenspan to an audience in Hong Kong. The market
break and resulting turmoil in the Big Media verged on
a systemic risk event and caused the usually indifferent White House to issue a statement, expressing confidence that the
steep decline in global equity markets is "a normal correction."
For many in the financial markets, normal
is no correction at all -- or at least one that lasts only
a day or so and is painless in career terms. That is why we have things like the plunge protection team (aka the
Working Group on Financial Markets) -- to maintain confidence, even as US economic fundamentals wane. But
we start to resemble a conspiracy theorist...
The IRA noticed
the market's gyrations at the time and, like most of us all, we went back to
our chores when the market indices resumed their expected northward
But the following month, we got pinged by a fellow member of Professional Risk Managers International
Association, who asked if we had noted the miscalculation of the Dow indices during the sharp market sell-off in February. Our colleague likened the event to "systemic information risk" and asked if this was not a precursor to a bigger, more messy event in the future.
Since that blog contact, we've spoken to a number of our colleagues in the risk management world and continue to hear tales of systemic stress coming out of the February market correction. By far the most surprising and remarkable reports, which come from senior operations officers of two bulge bracket firms, is a large jump in "breaks and fails" which apparently occurred during the two days of market carnage.
Last week, we
circulated an informal questionnaire to our colleagues in the risk management
world, asking a basic question: Did your firm see an increase in settlement
breaks or fails during the 2/27-28 period, particularly fails for settlement of
cash market equity trades?
To give us feedback on a confidential basis, click here.
One report of sharp increases in broken and failed trades described a situation where exceptions went from 20 pages to over 500 pages for 2/27. Colleagues were compelled to spend days working round the clock manually sifting through each fail and making a decision whether the firm need to cover a given transaction exposure.
"If 1987 was a 13 standard deviation event, February 27 was a 6," says one player involved. "We saw peak trading volumes almost double during that two days, but the number of breaks and fails expanded exponentially, far out of proportion to the volume increase." The same source claims it took his firm and others weeks to mostly dig out from the surge in bad trades, a process which continues even today.
which catches our attention about anecdotal reports of back office
blockages in February is that they are focused on the cash equity markets,
not OTC derivatives where everybody thinks the BIG operational risk
resides. One of the observations we've
heard over the past couple of days is that back office systems only scale to a
degree. When trades must be processed by hand or corrected, the throughput of
the organization slows to the same pedestrian pace as that for OTC
A big issue
we hear repeated over and over concerns reduced head count in back office functions, this due to
the wide spread of automation, leaving major financial institutions dependent on
a relatively tiny cadre of specialists for any clearing mishaps. The vast
expansion of the investment world has given experienced back office professionals choices when it comes to employment, leaving larger, productivity-obsessed organizations with a precious handful of people who can perform all of the tasks required to settle a trade manually.
"We manage all of our risk by
exception, using automation to manage the event flags," one senior bank credit risk
officer told The IRA last
week. "But we have less than 20% of the people we did five years ago, managing
much bigger trade volumes. Getting the marks [to market] and the systems right
is crucial for us."
Another manager observes: "I am
the only person on my floor who knows how to do everything in the settlement chain. When I started in the business, everyone in operations sat together and learned the process end-to-end. Now everybody is a specialist sitting alone in an office. When failed trades start to accumulate, we can only scale to a point."
The assumption is
that modern cash securities markets are so automated and well-supported by
electronic infrastructure provided by the private exchanges and clearing
houses that an increase in volume is easily accomodated, but what if this
assumption is false?
What if the surges in equity market volume
observed over the past year or more are warnings on an impending breakdown in
cash market clearing and settlement infrastructure? And what if,
after the Street has spent billions improving and adding redundancy to
trade clearing systems post 9/11, the weak link in the chain is not the
hardware but a lack of skilled back office professionals?
So here's the question: Did your organization observe a "normal
correction" in the final days of February? Did your firm observe increased
numbers of breaks and fails on 02/27/07? Either as an investor or a dealer, did you
see evidence of systemic stress on the cash settlement markets?
responses will be held in confidence and reflected in a future issue of The
Institutional Risk Analyst.
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