Yves Smith: Big traders use automatic algorithmic trading and make money from volatile markets - August 10, 2011
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Yves Smith has written the popular and trenchant financial blog "Naked Capitalism" since 2006.
Yves has spent more than 25 years in the financial services industry and currently heads Aurora Advisors, a New York-based management consulting firm specializing in corporate finance advisory and financial services. Prior experience includes Goldman Sachs (in corporate finance), McKinsey & Co., and Sumitomo Bank (as head of mergers and acquisitions). Yves has written for publications in the United States and Australia, including The New York Times, The Christian Science Monitor, Slate, The Conference Board Review, Institutional Investor, The Daily Deal and the Australian Financial Review. Yves is a graduate of Harvard College and Harvard Business School.
PAUL JAY, SENIOR EDITOR, TRNN: Welcome to The Real News Network. I'm Paul Jay in Washington. Now joining us to talk about the meltdown on Monday of the global finance markets is Yves Smith. Yves is the founder of nakedcapitalism.com. Thanks for joining us again, Yves.YVES SMITH, NAKEDCAPITALISM.COM: Paul, thanks so much.JAY: So here's--explain this to me. On Friday, we have the downgrading of US sovereign debt by S&P. On Friday and all over the weekend, all the commentators were saying this is politically motivated, no one's going to stop buying Treasury bills because of this, no one believes the US can default--so on and so on. And, in fact, I heard one of the money market managers on TV today saying he thought on Friday not much what happened on Monday, except all the big institutional investors started selling like mad. So why?SMITH: Well, this is really a stock market reaction, not a bond market reaction. If you look at what happened in the bond markets, the--and we probably need to back up sort of to one higher level of abstraction. But what happened during the day was in fact the Treasuries went up. They had weakened somewhat overnight, but all the central banks had basically said that they weren't going to give up buying Treasuries. The major money managers had said they weren't going to give up buying Treasuries, and that most people expected that there might be some panicked selling by people who were blindsided by the downgrade, and that once the interest rates had gone up high enough, that other buyers would swoop in and buy them. Now, what instead happened is that--remember, everybody in the US is very fixated on what's happening here. The much bigger story, frankly, and what appears to actually be the trigger, even though it's not being reported that way in the popular media, is what's happening in Europe. The Spanish and Italian bonds--and those are--Italy in particular is too big to save by any standards. Those bonds started widening very significantly on Friday, and that was because the ECB had basically said that it wasn't going to support the debt of those countries [crosstalk] JAY: Okay. Let--just quickly, let me just say, widening means the interest charge on these--.SMITH: Rate goes up, which means the prices go down. So here you have sovereign governments and their spread over Germany, which is now perceived to be the benchmark funder in that group, went up tremendously, to the point where it would cause the governments problems. They all have--they all have debt that they're going to have to refinance at some point in the next year or two. And the irony is, with Italy, that it really is much more of what you would call a rollover risk problem than a solvency problem, per se, because they, even though they have a very high government debt, almost all of it is bought by Italian savers. But still, if the market interest rate is really high, the Italian savers are going to expect that when their bonds mature and the government sells those new bonds, that they're going to get those high interest rates. So in any event, so the important thing was for the European Central Bank to step in and demonstrate some support, that there has been--because there's a big difference between a liquidity crisis and a solvency crisis. If people panic, you need a central bank to step in and provide liquidity to calm the markets. If you've got a real solvency crisis, which is what we're seeing in Greece, you need to go down a different path. You need to basically restructure the debt, which isn't happening in Greece. So we're not doing the right thing--they're not doing the right thing in Greece. And then--which has already got people alarmed. And then we have the problem spreading to Italy and Spain, and the ECB has been sitting on its hands. So over the weekend they had a whole series of panic meetings among the G-7, and there've--and I've heard from people who know staff at he ECB that there are increasingly bitter fights at the board level about what to do. And the--over the weekend they announced that they were going to buy bonds. Well, the markets opened in Europe. They didn't buy bonds.JAY: Just let me--just let me quickly say, for those that aren't following, ECB is European Central Bank.SMITH: Is European--right. So the markets opened in Europe. The ECB--. Now, the markets had behaved badly overnight in--but not that badly, frankly, I mean, given that the downgrade surprised people. Two to three percent down is bad, but it's not a--I mean, it's not a disaster. I mean, that's sort of at the low end of bad daily move. And the European markets opened down 2 percentage. And the central bank initially--the ECB didn't come in and buy. And then in the middle of the day it did do some buying, and the markets went up to almost flattish, and then it stopped and they started decaying again. They started decaying in a very serious way. And then the US markets basically opened up in sympathy with what was happening in Europe. They had been--they had been, overnight, down about 2 percent to 3 percent. They opened down about 3 percent. And then what happened during the day is they sort of stayed around the 3 percent level. Then Obama speaks, and the market started tanking from there. It went down during his speech, rallied a little bit afterwards.JAY: This is his confidence-building speech.SMITH: His confidence speech shot the market in the head. I mean, his confidence speech, the decay at the end of the day, the Obama speech, no question, made matters worse, I mean, 'cause it basically demonstrated that he was out of touch, which is not--.JAY: So if you go into the process of this, this kind of movement means big institutional investors start selling. And they all know that if they start this, it's going to lead to this big--what we saw, a big drop.SMITH: Actually, not necessarily, because remember 70 percent of New York Stock Exchange trading is now this crazy algorithmic trading. So it's really not people--JAY: Well, that's what I was getting at. That's what I was getting at.SMITH: --it's not really people with brains. I mean, that's the whole thing. This could, you know, very well be that the algos--. I mean, this--a different version of the same thing happened in the '87 crash. You again--the trigger of the '87 crash was in fact a completely different form of automatic computerized trading known as program trading. And that--and so I haven't seen any analysis of actually what happened during the day, but it could be that, frankly, people got nervous during the Obama speech, and then the--they call it the algos kicked in.JAY: Well, I was talking to someone, actually, Bart Chilton, who's the commissioner of the Federal Commodities and Derivatives Commission, and he said to me that of 35,000 people working at Goldman, 1,000 are working on algorithms.SMITH: Yeah.JAY: So this could be that kind of play. On the other hand, you don't let that kick in unless you--I mean, is it--you don't turn it over to that unless there's something in it for you. I mean--.SMITH: Unfortunately, unfortunately, you do. It's highly automated, pattern-based trading, and they're trying to beat other people by nanoseconds. So in fact it--now, at Goldman, there may be some shops where they actually have some form of manual overrides, but a lot of the shops that do this are actually boutiques that only do this kind of trading, and it's highly automated. So there are a lot of players which I would doubt that have any kind of overrides on their systems.JAY: Well, one of the commodities traders I was talking to a few days ago, he says to--he said to me that part of what goes on in these kinds of enormous drops is the big players don't mind the drops, 'cause the small players get wiped out, and then the big players sitting on cash buy back in. Do you think that's a factor here?SMITH: Well, no, that--I mean, I was--you know, I just spoke to somebody who's--late this afternoon, a world-leading derivatives expert, Satyajit Das, who's actually based in Australia, and he was saying this is the kind of market traders love. They make a lot of money on volatility. This is the perfect market for those kind of big--you know, those kind of big, aggressive traders.JAY: Right. So what do you think should be done? I mean, I saw on Naked Capitalism you wrote a piece called Obama does own this crisis. So why do you say that? And what could he have done differently?SMITH: Well, the big mistake he made was letting this--letting the debt ceiling crisis even occur, I mean, because, frankly, as you recall, Obama came into office literally before he even--the week he took office he was talking about entitlement cuts. This was something he wanted to happen on his watch. And so when the Republicans were--ironically, in the wake of the Obama victory, the Republicans were strategizing on what they could do to gain ground, and they wanted to make something out of the debt-ceiling crisis. There was an excellent story in The Washington Post that I'm sure a lot of your readers saw over the weekend on that. Obama played right into that. You know, he had routes where he could have circumvented the debt and called off the bluff early on.JAY: Yeah. In fact, Jon Stewart had a great clip of an Obama press conference where journalists over a year ago asked President Obama, when they were negotiating the Bush tax cuts, whether he was going to follow the advice of those who were saying, if you are going to make a deal to extend the tax cuts, you should at least connect it to the debt ceiling and don't allow the debt ceiling to be used against you a year from now. So it wasn't like he wasn't aware of this as a possible strategy.SMITH: Oh, exactly. And then, to top it off, you know, it was discussed numerous places that he had several ways out. You know, one was using the Fourteenth Amendment. He backed off from that, claiming that his lawyers advised him he couldn't use that. Well, ironically, one of the lawyers who acted as a human shield, Lawrence Tribe, who's a Harvard constitutional law professor, wrote a very strange New York Times op-ed. It was very peculiarly worded. And then Tribe himself has basically subsequently said that, oh, gee, there's no point of entry for anybody to challenge this legally.JAY: Right. In fact, Bill Clinton said he would have used it.SMITH: Right. And then he had other routes that were more unusual but were viable. I mean, one of them would be to have the--to cancel the debt held by the Federal Reserve. That would be controversial, but that was theoretically an option. And the other one was--which is called coin seigniorage. It's a very unfortunate [incompr.] But basically the US Mint has the ability to create platinum coins, and they can put any denomination on them they want to. So they could create one little coin, call it a trillion dollar coin, sell it to the Fed, the Fed would have to pay the Mint for it, and the profits would be swept into the Treasury. JAY: Right. So now that they've made the deal, now that the markets have, you know, spiraled, and the consequences of this, I guess, we don't know yet, the debt rating is certainly going to affect if--not really the Fed's, but it's--could really affect state borrowing, municipal borrowing, and the ripple effect of this downgrading, which affects everybody's social programs. What should people be demanding? What would be the alternative policy right now?SMITH: Well, the problem is he's again painted himself in a--. I hate to say it. He's left himself with--. This is why I said Obama owns this. I mean, if it were somebody other than Obama, they could go to the Republicans and say, you know, we're going to increase spending. Well, he's bought the premise, he's bought and pushed the premise that we need to cut deficits. This is the wrong time to do that. You know, the time you do that is when the economy is good. And since governments tend not to have the discipline to do that, the best way to address problems in times when the economy is weak is through programs like food stamps, programs like unemployment insurance, so that when the economy gets better, this automatically--the spending on that automatically falls off. That way, you don't have to worry about government discretions in terms of the spending going down when the economy improves. But he's basically painted himself into a corner. I mean, the only thing that the government can do at this point, really, is action by the Federal Reserve, and that's--when interest rates are this low, they're limited to what they can do. I mean, they can possibly stabilize the markets. I say possibly because with the Tea Partiers in charge, I think people are less confident in the ability of the Fed to stand up and do the sort of stuff that it did in the crisis once again.JAY: So given the reality of the politics, what do you think's going to happen the rest of this week?SMITH: Well, unless we have some pretty dramatic action, I mean, I could--. Now, the flipside is I could easily--. I see a lot of panic right now. I mean, the flip side [incompr.] people say that the markets are oversold. And I think if there was any excuse, you could see a short-term snap-back rally. I mean, that was one of the things we saw in the--I mean, this is--we're still not to crisis--even though a 6 percent stock market decline is gut-wrenching, we saw even bigger declines during the crisis. So we're--but one of the characteristics of the crisis was violent snap-back rallies. You know, you had these sort of one-day enormous rallies as well. So I--one thing that's pretty certain is we're going to have a wild ride until people start feeling more confident that the officialdom is in charge and has a plan for doing something intelligent. I mean, even if it's a plan that's sort of long-term, frankly isn't very positive, they want to see some demonstration of leadership. And that's what they didn't see when Obama spoke, and that's what they didn't see from the ECB today.JAY: I saw a guy on TV today, a money market guy. He talks about sovereign raiders in Europe, and the next raid could be Belgium. If this continues in Europe, I don't see how this change--how this doesn't continue to unravel. I mean, if Europe continues to unravel, this whole thing continues to unravel, doesn't it?SMITH: But that's the whole thing. Europe--. You know, we have an economic problem. Europe has a basic existential problem. They've got real political problems about how the EU is going to work going forward, which make, you know, this false deficit crisis--. You know, it's like everybody here's decided to put on this crazy hair shirt and won't take it off. I mean, we could take off the hair shirt, but we--the critical actors have put themselves in a position where they're not willing to do that. In Europe there isn't--there's even more disarray in terms of the number and the complexity of the problems they have to solve to move forward.JAY: And the banks don't seem to--the banks don't want to take anything on the chin here in Europe, or here, for that matter, and that seems to be the underlying problem.SMITH: Yup, it does.JAY: At least one of them. Thanks very much for joining us, Yves.SMITH: Thank you, Paul. Take care.JAY: And thank you for joining us on The Real News Network.
End of Transcript
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