MF Global Stand Down Order Questioned For First Time

It was October, 2012 and the Futures Industry Association (FIA) conference was winding down at an eerie point in time.

It was near Halloween, an event that will always bring back clear memories of the MF Global criminal incident.  One year later I was questioning newly minted CFTC Commissioner Mark Wetjen about a troubling topic.

The issue questioned occurred on November 1 2011, one day after missing money made clear headlines, MF Global legal representative Ken Ziman had walked into a Manhattan courtroom and made the claim that “All funds were accounted for…”

Mr. Ziman, an attorney for Skadden Arps, had been hired by MF Global executives the previous week as they planned for the firm’s bankruptcy, a key point.  Mr. Ziman was in court in the Southern District of New York testifying on orders from his client, he said in a phone interview.  Those orders were to provide a report that obfuscated known facts, a point questioned by a University of Washington professor in the December issue of OFI.

It is unknown if Mr. Zinman delivered this testimony with a straight face, as it was documented that regulators and MF Global executives were aware  the previous day customer assets had disappeared from segregated funds under known suspicious circumstances.  It was later learned CFTC investigators are on record as being ready to mount a vigorous defense of the most sacrosanct of accounts in the regulated derivatives industry, yet a stand down order appeared to have been given.  How else can one explain the fact that all regulators were silent when material information was presented in court under false pretense?  There can be no dispute that funds were missing under suspicious circumstance and regulators are documented to have been aware, yet the MF Global legal representative was allowed to make a misleading claim that impacted control of MF Global after the bankruptcy – control of continued asset transfers and evidence.

November 1, 2011 an order was sent from regulators to their legal representatives attending the courthouse drama.  This was the first of at least three documented stand down orders to have occurred during the investigation, is the speculation.

It was this incident to which Commissioner Wetjen received tough questioning as several reporters watched. To read about the full account, refer to the November 2012 issue of  Opalesque Futures Intelligence (OFI).

CTA Analysis Starting With Beta Performance Drivers

When analysis of a CTA begins, where is the appropriate place to start?

This article makes the point that beta performance drivers are the logical starting point.  This is important from a number of perspectives, including correlation and determination of the proper considerations for CTA analysis going forward.

Performance Drivers Not Often Discussed

At its core, the CTA strategies have market environments in which they perform positively and negatively.  This is considered a beta performance driver.

By first recognizing these macro performance factors, the asset manager can describe the investment in terms that sets performance expectations and fits within typical equity analysis protocols.

Obtaining this information can sometimes be a challenge, however, as some CTAs prefer to obfuscate their strategy or might not understand the beta performance concept. The key is to recognize the difference in performance drivers in various strategies and do so through a categorization system that is not uniform.

In the case of trend following, the beta performance driver is price persistence.  When the price of a traded asset continues to move in one direction, either up or down, this price persistence is generally considered to be beneficial to the strategy; conversely. when the market environment changes towards a directionless trading environment one might expect CTA strategies to exhibit difficulty.  Compare this to a relative value strategy, for instance, that operates under a macro performance driver of divergence and convergence back to a statistical mean.

Challenges Extracting Information  

What can be a challenge is the categorization of different strategies.  Some strategies are called breakout strategies, momentum algorithms or just plain trend following.  In all these cases, the strategy is based on the beta performance driver of price persistence and is thus understood first from this perspective.

In any trend following strategy, when the market environment of price persistence is present the strategy has potential to perform positively; conversely, when the market environment of price persistence isn’t present the strategy can exhibit enhanced risk.

Each of the major CTA strategies is first considered from this beta performance driver standpoint.  From this alpha factor analysis is undertaken, which uses different factors for analysis depending on the beta performance driver.  For instance, a strategy influenced by the performance driver of price persistence had different analytic priorities than does a volatility CTA.

Next Educational Piece:

Second Educational Piece: First Understand Strategies From the Standpoint of Market Environments and Performance Drivers

Third Educational Piece: Examples of CTA Analysis based on performance driver factors.

Can Market Volatility Be Predicted? I say no; Scott Reamer, CIO at volatility trading program Rotella Chora, disagrees

Unfamiliar to even many sophisticated asset managers, volatility investing provides unique opportunities for risk management and market understanding.

Volatility investing involves trading programs based on market price volatility.  The primary volatility market is based on the stock market, but variations of volatility investing methods are used in commodity markets as well.  In light of an approaching debt crisis and always unpredictable world events, volatility-based investment techniques, both long and short, are worthy of detailed investigation.

A recent educational opportunity sponsored by AlphaMetrix and the CBOE Futures Exchange revealed interesting issues as it relates to the debt crisis and volatility investment techniques.  In addition to stock and commodity option contracts, one of the primary methods of volatility trading occurs with the VIX, the CBOE’s popular measure of implied volatility in the equity market.

Did Volatility Skews on December 21, 2012 Reveal a Market Imbalance?  

“Just before the conclusion of the fiscal cliff debate, the time horizon spread in the VIX options exhibited unusual expectations,” noted Christopher Cole, managing partner at Artemis Capital Management and one of the panelists.  “We could buy the front month VIX options and sell the back month with a positive carry.”  This is unusual because such a long volatility position typically involves the purchase of premium, but in this unusual relative value situation the trading manager collected premium and had long volatility exposure.

“What was the shoe that was expected to drop?” questioned Bruce Rogoff who, as managing partner of option market making firm Gargoyle Group, noted highly unusual professional action leading up to the fiscal cliff negotiations.  “And when is that shoe expected to drop.”

Behind the scenes, derivatives professionals have been observing the mathematical properties of the US debt crisis for several years.  While predicting the exact date of a potential volatility implosion is speculative, what is known is there is a certain point at which compounding on the debt and a continued path of deficit becomes unsustainable, potentially leading to a transformational market crash.  While the date cannot be predicted, the mathematical underpinnings of the problem are generally understood along with the practical knowledge of the likely political battles that could arise out of the problem.  If the US debt crisis is left unaddressed, speculation is a transformational debt crisis crash could occur within three to five years, while more conservative estimates indicate a 10 year time horizon.  Just like former CFTC Chairperson Brooksley Born predicting the OTC derivatives would eventually cause a market crash, she didn’t know the date would be 2008 but a logical understanding of derivatives structure and mathematical probability also indicates that at some point a debt crisis crash should be considered.

Can Market Volatility Be Predicted?

Perhaps one of the more interesting discussions to take place occurred regarding the predictability of market volatility.

“Volatility can be predicted,” said Scott Reamer, CIO at volatility trading program Rotella Chora.  In subsequent conversations Mr. Reamer, who operates a short-term time horizon volatility strategy, observed that even longer term volatility events can be predicted to a degree based on structural instability leading up to the event.

It has been assumed that volatility can be more easily subject to a probability table on a short term basis, due to the cyclical nature during a given trading day, week or month.  It is the major volatility events, such as September 11, 2001 that would be difficult if not impossible to predict just by looking at previous pricing data.  To this Mr. Reamer responded the insight that a pattern of structural instability often led up to major volatility events.

Fascinating conversations to be sure.



HTF Regulatory Challenge: Define High Frequency Trading

How does one define a previously un-definable topic such as High Frequency Trading (HFT)?

Sources close to the Commodity Futures Trading Commission (CFTC) indicate new thinking may be underway regarding the topic of High Frequency Trading (HFT). Speculation is this thinking could look at the relative market impact HFT may have in a given market move as a legal definition. Such a definition could consider the relative impact of a particular HFT player as a percentage of a market damaging move and could be used for potential CFTC action on the issue. This new thinking could be outlined sometime in March, sources told Opalesque.

Current US regulation regarding HFT is considered by some market participants to be behind the curve relative to the European Union. In the EU, for instance, algorithm type is used as an identifier to determine market participant behavior during crisis conditions.

“There is significant uneasiness on the speed in markets,” noted Vassilis Vergotis, Executive Vice President, Head of Eurex, Americas.

Dr. Randolph Roth, Executive Director at Eurex, noted the difficulty to define HFT and how speed was now being used as a risk management tool: “HFT is about technology that enables a strategy.”

The Eurex exchange monitors market participant based on strategy, differentiating between HFT proprietary directional traders and commercial interests such as investment banks and what is known as “real paper” institutional orders.  In a press presentation, Eurex displayed a study that illustrated during a single market crash on August 25, 2011 they had identified HFT traders in the market and it did not contribute to the fall in price of the stock market.  This date was similar to a “Flash Crash” in that a large number of sell orders swamped buyers in a short period of time.  On this day, a time when the market was already skittish over the US debt downgrade, the Eurex market with an order to sell over 6,000 DAX stock index futures contracts over a 15 minute period of time.  When a sell order from apparent “real paper” entered the marketplace, this apparent institution scared buyers.  “Who catches the falling knife?” is a question that volatility circuit breakers are attempting to better manage.

Do HFT cause market volatility?  No, claims Dr. Roth.  “The objective is to improve latency, reduce unwanted trades and provide real time risk management.”

Can The Next Flash Crash Be Better Managed With a Volatility Interruption Algorithm? Does Eurex Exchange have the answer?

A significant issue with High Frequency Trading (HFT) has always been defining the activity and related behavior during times of crisis.

“The issue is HFT impact on market stability,” noted Dr. Randolf Roth, Head of Market Structure for the Eurex Exchange.

With the May 6, 2010 Flash Crash in mind, Eurex exchange officials detailed their proprietary “Volatility Interruption” algorithm.  The algorithm is essentially a trailing look-back trigger that provides markets a cooling off period when abnormal volatility is detected.

“This is different from a traditional exchange circuit breaker,” said Vassilis Vergotis, Executive Vice President, Head of Eurex / Americas.  Exchanges traditionally stop trading simply based on a given percent price move in a giving market.  For instance, if the price of corn were to trigger a circuit breaker in the S&P 500, for instance, trading might stop once a 20% down move in price occurred.  Such “lock limit” moves are imposed on a daily basis, on an exchange by exchange basis, and did not prevent the Flash Crash due in part to the speed in which a crash can gain momentum.  In an electronic trading world, the use of high latency “electronic eye” technology is utilized by HFT and electronic market makers to monitor and predict liquidity disparity and volatility.  The key is the speed with which a market flash crash can gain momentum quickly and on small volatility spikes.

Mathematical Logic Drives Protection

Noteworthy is the sophistication of the Eurex algorithm.  Moving past simple daily price limits, the algorithm has a volatility detection feature that operates over a shorter time period.  If abnormal or potentially damaging crash volatility is detected, a systematic decision process ensues that stops market trading until calm can be restored.  This is important in avoiding a volatility flash crash because it could diminish the potential for cascading stop orders to be executed.

The exchange says the algorithm has been used on average under ten times per year in the derivatives markets, while its use at the Deutsche Boerse stock exchange might occur several times per day.

Looking at the distribution of liquidity, the algorithm provides traders a “cooling off period” that allows calmer heads to prevail.  “We’re trying to avoid the issue of cascading stop orders,” Mr. Vergotis said. Cascading stop orders occur when a market experiences volatile price moves in a short period of time, triggering automated sell or buy orders.  Such market environments can trigger cascading stop orders which, in extreme circumstances, might trigger “Flash Crash” type circumstances.

Discussing the sophistication of the algorithm, Eurex officials addressed the mathematical model has relative overrides while not disclosing the specific math.  Interestingly, the interruption algorithm was a variable defined by how the trading day started.  For instance, if trading on the day started without volatility but then experienced a sudden pick up in volatility, the algorithm would shut down trading quicker than if the trading day started with volatility and then moved to higher volatility.  Further, if the algorithm detected abnormal distribution of bids and offers, this trigger could shut down trading for a variable length depending on the significance of the volatility.  The average length of a market shutdown might be 2-3 minutes, upon which an auction process precedes stabilization of distribution of market bids and offers.

While no system is perfect or guaranteed, particularly under flash crash circumstances, risk managers are advised to stress test mathematical logic during periods of market crisis.

What’s Missing in the Debate over Residual Interest Income: Monopolistic Control Over Futures Industry Brokerage

While it sounds mundane, the “Residual Interest Income” issue has the potential to literally change the face of the regulated derivatives industry.

In just one line of a massive Dodd Frank bill with unnecessary complexity and obfuscation, large bank interests may complete monopolistic control over the derivatives industry.

This is the point that has been absent from many of the industry comment letters and should be on the radar of government regulators.

To understand, keep the topic simple.

With one line amongst millions of legislative words, government regulators will effectively dis-advantage mid-sized Futures Commission Merchants (FCMs), likely forcing many out of business, which has been widely discussed and commented on.  The point missing in discussions is the implications, the “unintended” consequences of how this provides literal control of the futures brokerage industry by a small cartel of banking interests with a Too Big to Fail guarantee.

Monopolistic control over the futures industry is not a new topic.  The discussion has always taken shape on the exchange side of the business.  Brokerage has not been actively considered in the public discussion, but the impact could be the same.

Consequences for farmers and hedgers could be dramatic, as most of these independent business executives work with mid-sized brokerage firms.  In effect, this could impact the stability of the market, which is why certain large bank executives might have taken the side of independent FCMs.

In particular Mike Dawley of Goldman Sachs has been a vocal voice in the logical questioning of the impact on market ecosystem, as have many industry participants including The Commodity Customer Coalition and The National Introducing Brokers Association, who stands to be decimated if the “residual interest” issue is allowed to create a large bank monopoly in the commodity markets.

At a minimum the long term impact of this issue should be studied by the CFTC and openly discussed relative to the impact it might have on hedgers and creating a monopoly in a key sector of the US financial services industry.

Hedge Fund Legend Stanley Druckenmiller Talks Debt Crisis Truth

Hedge fund legend Stanley Druckenmiller made a rare appearance on CNBC to discuss the debt crisis with Maria Bartiromo, who appeared to keep pace with him step for step.

Mr. Druckenmiller has been talking the debt crisis about the debt crisis in similar terms to other alternative fund managers at all levels.  Not only large names such as managed futures legend Ray Dalio who has logically predicted political chaos if the debt crisis is not addressed, but anyone with a mathematical mind recognizes the inevitable.

But it is Druckenmiller who so toughly understands the topic, as was on display in the interview.  He noted the market will figure out the debt crisis math and take action long before the real event.  Significnatly, Mr. Druckenmiller recognizes the coming entitlement tidal wave that could literally swamp the budget in red ink.  Perhaps for this reason he pegged the timing of a bond market implosion in the 4-5 year range.  Other projections have put a ten year time horizon in place while my aggressive projection has been in the 3-4 year range.  These projections are not just based on the math, but the logical market reaction and likely volatility that might arise.

Solving the problem requires politicians touching third rail issues: reducing spending and increasing revenue.  This isn’t just a tough problem it is the toughest problem political leaders will face.  And the problem will likely be addressed by markets before the government can no longer support itself.

Government will not likely reach the point where defacto default takes place before the markets react.  Problem is, Mr. Druckenmiller notes, is bond market reactions are manipulated.  This has been sending the wrong message to political leaders.  Now is the time solve the problem.  Political leaders need motivation to solve the problem.  President Obama’s sequestration was really the wisdom of Soloman in attempting to place a guillotine over the heads of political leaders to compromise.  It didn’t work. One might assume had the bond market been giving political leaders the appropriate messages, this moment to “solve the big problem” might not have been squandered.

NFA Board Holds Off Lifetime Ban On Jon Corzine… For Now

The National Futures Association Board of Directors did not immediately act on a motion to ban former MF Global CEO Jon Corzine for life, but left open to possibility of the self regulator taking action after ongoing investigations currently underway by other government agencies are complete.

“Once the appropriate agencies have completed their investigations, NFA has the authority to bring disciplinary action against Mr. Corzine for violations of any NFA rules that occurred while he was a member,” according to a statement from the NFA. “The sanctions for disciplinary actions could include a lifetime ban and significant monetary fines.”

Sources indicate the NFA board had mixed feelings about the Koutoulas / Roe proposal to ban Jon Corzine from membership.  While damage done to the commodity markets has been significant, an investigation into MF Global executives initially appeared not to take place.  Official sources close to the investigation were quoted in The New York Times as saying the “case was cold” before MF Global executives were questioned, despite the fact that criminally suspicious information was available in the public record.  Arguments against the motion likely included jurisdictional issues with other regulatory agencies, the fact Mr. Corzine currently is not an NFA member and interference with ongoing investigatory efforts.

“The Board notes that Mr. Corzine is not currently a member of NFA. The Board is aware of publicly available information that raises issues concerning Mr. Corzine’s fitness for NFA membership. If Mr. Corzine applies for membership in the future, he will not be granted membership unless NFA, after completing its fitness investigation, resolves those issues to its satisfaction.”

Documenting the Journalistic Tone Regarding Financial Crimes & MF Global

It took 60 minutes (CBS) and Frontline (PBS) to publicly document what had been known to many inside the derivatives industry.

In 2008 derivatives crime that cost the US economy $12.8 trillion were not prosecuted.  But worse yet, these crimes were not properly investigated, media reports show.

2008 led to further criminality, it can be argued.  One can logically assume that HSBC executives might have thought differently about laundering money for drug cartels, Iran and terrorist groups if there was a realistic specter of criminal punishment.  That’s deterrence  not vengeance.  More significantly, the apparent blatant criminality and brazen disrespect for regulatory authority might not have been on display in MF Global had deterrence been in place.

Documenting The Journalistic Tone

What’s fascinating is documenting the journalistic mood relative to what can only be described as criminality that has significantly damaged the world financial system.

At first journalists I follow appeared not to think deep seated, intentional criminality was at play.  They assumed the crimes were complex and prosecution difficult.  The mantra with MF Global, for instance, was: Prove the criminality and MF Global executives will be convicted.

Now that inside indications regarding rampant criminal behavior are slowly working their way into the media consciousnesses – and knowledge  Department of Justice ignored hard criminal facts in 2008 — a different tone among some in the media appears to be taking shape.

Apologists for Big Bank Criminality Taking the Wrong Approach

Now that MF Global crime is more reticently clear, and DOJ’s apparent official policy for not investigating certain institutions and individuals, some in the media are changing their tune.  However, while the majority seem to be open to discussing real issues and see the clear absurdity — if not constitutional crisis — caused by not investigating and prosecuting “untouchable” individuals, some cling to the past.  Some have apparently defended Wall Street crime as part of the necessary price a society pays to promote big bank monopolistic dominance in financial services.

Take CNBC host and New York Times columnist Andrew Ross Sorkin.  Mr. Sorkin is the respected author of Too Big to Fail, a book and later movie.  Insiders note the story somehow did not get into some details regarding a highly suspicious transfer of assets from Bear Stearns to an unmentionable large bank counter party that surrounded the bankruptcy.

Fast forward as the public discussion of actually investigating financial criminal behavior heats up.

Speaking on MSNBC’s Now with Alex Wagner, Mr. Sorkin apparently hops on the big bank defense  team.  Note at 4 minutes in the interview how the clear topic was holding bank executives to criminal accountability, and Mr. Sorkin changed the topic to a defense of the Too Big To Fail guarantee — another topic where the truth has yet to see the light of day.  The topic of discussion had been the lack of criminal prosecution, and Mr. Sorkin moves to what some might consider a threat: discussion of the need for the large banks in our economic system.  It had nothing to do with the criminal topic at hand.  Later at 7:50 of the interview, Mr. Sorkin again diverts the topic.  He addresses the topic of “going after” JP Morgan. No one is saying JP Morgan needs to be held criminally accountable, but individual executives who violate the law can be strategically targeted without bringing down the institution.

Rules and laws have not changed.  We will know if MF Global prosecution is serious if it focuses on the clear criminality and tells a simple story.  The more complex the story told by DOJ regarding MF Global, the louder the signal that criminal actions are being allowed to damage the US financial system.

We are at a historic moment in time.  A clear signal must be sent to a minority of Wall Street criminals.  Let’s keep an eye on MF Global as it will be the tipping point towards Wall Street justice.