The Last Look…
Posted by Colin Lambert. Last updated: March 14, 2022
Long-time readers will know I have issues with repapering trades unless it is a genuine “fat-finger” error – a panic sell in a crashing market is not such an event, it is a trader or execution agent losing their head and really believing that, for example, the euro has suddenly lost 80% (or more) of its value against the Swiss franc.
Last week we saw similar events on the LME as Nickel doubled in price, leading to the exchange to effectively cancel a whole session. I don’t know many active metals traders so my sample set is minute, but I did manage to speak to two people both of whom had the same question – how can you cancel trades that both parties are happy with?
Apparently a Chinese Nickel producer had built up a large short position in recent months, expecting a price drop – which, of course, didn’t happen. This firm then started aggressively squaring its position both to cut its losses and to mitigate what were likely to be seriously large margin calls. News of the position also got out, somehow (total transparency perhaps, which begs its own question) and the rest, as they say, is history.
How was what happened on the LME different to a market event that could happen at any time? I don’t know how the firm in question traded, but it’s the equivalent (or reality) of yet another dumb algo that keeps on buying regardless of market impact. If it was an algo, even if it was ‘smart’ the person operating it clearly wasn’t and was panicking. Liquidity dried up and…well it’s a familiar story to anyone in a market that has seen a flash event.
The thing is though, pretty much all of these flash events have been the result of trader or execution agent error. The ‘original’ flash crash in May 2010 in US equities was caused by a backwards looking algo that didn’t measure percentage of market activity, and in the Swiss event it was retail-orientated firms chopping their customers’ positions because the computer told them to, rather than considering what would have been a reasonable level for the cross.
What the LME’s action did was halt a market in the middle of a flash event, rather than let the whole thing play out as should have happened.
Don’t get me wrong, I am not saying that flash events can’t happen without trader error, more that trader error exacerbates the situation. That was the case in the SNB debacle – although I disagree with what it did, EBS’ established low on that day, while far above what it should have been under the strict interpretation of the rules, was probably a fair reflection of how far the market should have moved – 20 big figures for the fundamental shift plus the same again for excess positions being cleared out. The problem was not that the cross gapped 20 or 30 big figures, it’s that it carried on going as people started panicking and lost all sense of reason.
Probably a better comparison is the behaviour of Cable during and after Brexit. On the night of the vote the market read the tea-leaves after Sunderland and Cable was 20 big figures lower, but then it stabilised as prepared and measured minds estimated 1.25-1.30 was probably the right level (and they were, generally speaking, proven right). Hop forward a few months and the night when someone had a crack at an option barrier (I know, but I still believe that’s what happened based on the anecdotal evidence available to me) at an illiquid time of day, but then, after the trigger, another trader panicked and sent the market another 10 big figures lower.
What happened in Nickel last week was similar in nature. A player had a huge position in market terms, and had to/wanted to clear it out. The problem is they did it badly. Is that a reason to cancel eight hours’ worth of trades? It is also notable that when the suspension and cancellation came, the price was actually dropping and was some $20-25,000 off the peak.
In well-functioning markets, there is always a price. People start complaining and talking about how markets are “broken” when that price doesn’t suit them or, they don’t know how to price a moving market – a skill that has become something of a lost art in some markets and institutions
It seems to me that what the LME’s action did was halt a market in the middle of a flash event, rather than let the whole thing play out. When (if) it reopens trading, one assumes the price will be lower than where it was suspended, something that may help the Chinese firm in question, but will do nothing for the thousands of other participants that are currently in limbo, no longer have their usual price reference and probably are exposed to the reopening levels themselves.
This is a lesson, if ever we needed it, to let the market do its own thing – markets are, generally, really good at working this stuff out. Perhaps we need to establish some more sophisticated rules around margin calls, and perhaps more risk needs to be allocated to managing exposures in dislocating markets, but either way, if markets are to fulfill their core function of mitigating risk for those who want it, they have to be left to their own devices.
We will never know whether Nickel would have continued dropping and ended up close to opening levels (which were, to reinforce the point, significantly higher than days earlier due to fundamental factors), but we do know the industry is in chaos because of the trading halt.
The fact is, in well-functioning markets, there is always a price. People start complaining and talking about how markets are “broken” when that price doesn’t suit them and they face a loss or, perhaps more pertinently, don’t know how to price a moving market – a skill that has become something of a lost art in some markets and institutions, especially if the computer can’t do it.
LME is either a poorly-constructed market, or the exchange acted too hastily (it could be both of course). FX is built differently, so, hopefully it does not, and will not, have to cope with similar circumstances. I know I am a huge advocate for the FX market structure, but it is insightful, I believe, to contrast the experience of Nickel traders, left high and dry by world events, with those even closer to the core issue, rouble FX traders. It may be wide, but pretty much throughout the ongoing Ukraine crisis, EBS Market has had a USD/RUB price.
Liquidity is always there, but perhaps what the current generation of traders is finding out (as did their predecessors at one stage or another), is that it is not, as too many have become accustomed to over the past decade, guaranteed and without cost.