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Was ‘Black Swan’ Behind Stock Swoon?

From the Wall Street Journal:

Did a Big Bet Help Trigger ‘Black Swan’ Stock Swoon?


MAY 10, 2010

Shortly after 2:15 p.m. Eastern time last Thursday, hedge fund Universa Investments LP placed a big bet in the Chicago options trading pits that stocks would continue their sharp declines.

On any other day, this $7.5 million trade for 50,000 options contracts might have briefly hurt stock prices, though not caused much of a ripple. But coming on a day when all varieties of financial markets were deeply unsettled, the trade may have played a key role in the stock-market collapse just 20 minutes later.

The trade by Universa, a hedge fund advised by Nassim Taleb, author of "Black Swan: The Impact of the Highly Improbable," led traders on the other side of the transaction—including Barclays Capital, the brokerage arm of British bank Barclays PLC—to do their own selling to offset some of the risk, according to traders in Chicago.

Then, as the market fell, those declines are likely to have forced even more "hedging" sales, creating a tsunami of pressure that spread to nearly all parts of the market.

The tidal wave of selling fed into a market already on edge about the economy in Europe. As the selling spread, a blast of orders appears to have jarred the flow of data going into brokerage firms, such as Barclays Capital, according to people familiar with the matter.

Exchanges, in turn, were clogged by huge volumes of offers to buy and sell stocks, say traders and exchange executives. Even before some individual stocks collapsed to just a penny a share, data from the NYSE Euronext’s electronic Arca exchange started to appear questionable, say traders.

In the disarray, some huge superfast-trading hedge funds that now provide much of the liquidity for the stock market pulled to the sidelines. The working theory among traders and others involved in the exchange meltdown is that the "Black Swan"-linked fund may have contributed to a "Black Swan" moment, a rare, unforeseen event that can have devastating consequences.

"Universa alone couldn’t have caused the meltdown," said Mark Spitznagel, Universa’s founder. "We had reached a critical point in the market, and it was poised to collapse." Barclays Capital declined to comment.

As more details of last Thursday’s collapse become clear, there is less evidence to suggest a "fat-finger" data-entry error caused the collapse. Instead, the picture is one of a highly rare confluence of events, some linked, some unrelated, that exposed weaknesses in the stock market large and small. Within five minutes, the Dow Jones Industrial Average had lost 700 points as trading seized up in individual stocks such as Procter & Gamble and even exchange-traded mutual funds.

"It did point out that there is a structural flaw," said Gus Sauter, chief investment officer at Vanguard Group. "We have to think through how you preserve the immediacy and yet preserve the liquidity." …

The rest of this lengthy Wall Street Journal article gets into the inside baseball of trading on the floor.

But the involvement of Nassim Taleb, however indirect, and his ‘Black Swan’ theory is of considerable interest.

In ancient literature, a black swan was a proverbial phrase for something extremely rare or non-existent. It a rarity, literally a rara avis (rare bird).

Mr. Taleb uses the expression to epitomize a uncertainty, a randomness — which nevertheless appears to be deceptively predictable. And, as the article puts it, "a rare, unforeseen event that can have devastating consequences."

How this can apply to current international finances is spelled out in his 2007 book, ‘The Black Swan’:

Globalization creates interlocking fragility, while reducing volatility and giving the appearance of stability. In other words it creates devastating Black Swans. We have never lived before under the threat of a global collapse. Financial Institutions have been merging into a smaller number of very large banks. Almost all banks are interrelated. So the financial ecology is swelling into gigantic, incestuous, bureaucratic banks – when one fails, they all fall. The increased concentration among banks seems to have the effect of making financial crisis less likely, but when they happen they are more global in scale and hit us very hard. We have moved from a diversified ecology of small banks, with varied lending policies, to a more homogeneous framework of firms that all resemble one another. True, we now have fewer failures, but when they occur… I shiver at the thought.

The government-sponsored institution Fannie Mae, when I look at its risks, seems to be sitting on a barrel of dynamite, vulnerable to the slightest hiccup. But not to worry: their large staff of scientists deem these events "unlikely".

Mr. Taleb seems to have been calling for such a global financial collapse of our overly inter-dependent banks for some time.

So to have a hedge fund that he is advising be behind the recent historic drop on Wall Street is probably something of significance.

If true.

This article was posted by Steve on Tuesday, May 11th, 2010. Comments are currently closed.

4 Responses to “Was ‘Black Swan’ Behind Stock Swoon?”

  1. NoNeoCommies says:

    Just like the commodities trading of oil futures, this is open to manipulation by forces not friendly to the USA.
    The rub here is that they ‘should’ be able to pin down who did this while the commodities markets are known to mask traders.

  2. proreason says:

    The financial predators are just as eager to create and take advantage of financial chaos as the Obamarxists are to create and take advantage of all forms of chaos.

    They are allies in revolution.

    The one wants to cheat you out of your money. The other wants to cheat you out of your freedom.

    And they are both winning.

  3. tranquil.night says:

    I think we all knew in our gut last Thursday that someone was flexing their muscle to make a point.

    Once again, these manipulators are trying to show that the mechanics they invent and practice are reason to suggest that the system is fundamentally flawed and in need of change/more regulation.

    The point about the banks becoming more uniform in size and lending practice is valid – but that’s because government regulation has already forced them down that path. The banks hedge against the irresponsible lending they’re FORCED to make (i.e. through derivatives, etc). What’s even worse and more sinister is that certain forces from this coalition of big finance/big government seem like they keep dangling the carrot infront of the industry to lead them astray purposely.

    “We had reached a critical point in the market, and it was poised to collapse.”

    That’s the real reason for these black swans.

    There is market stability when there is actual stability. When there’s uncertainty, people leave. It doesn’t take a brilliant trader anymore to see where the dynamite in the market is; we’ve had an administration that’s tried to construct an economic rally around a minefield barely covered and disguised in newspaper.

    • proreason says:

      The market is rigged, or at least, it is easily manipulated by people with lots of money.

      And it could not be rigged without the compliance and support of the government.

      They are full and willing partners in crime.

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