Technical Issues Becoming New Source of Volatility

The last week has seen a series of technical glitches hit the market from different exchanges and trading securities (1)(2)(3)(4). These glitches have occurred with options, stocks and exchanges as well as institutional market players. Is this new? Actually, it is not, as there were issues related to Knight Securities, Facebook and other scenarios. (3)(4)

Should you be concerned? Yes. The issue of technical glitches fouling up the market mechanism can cost investors a lot of money. (3)(4) An added problem is that you have restricted access to your securities, or you may not get fair prices continuously, which is why markets were invented in the first place.  Another way of saying this is that liquidity may suddenly dry up or change quickly. This is an added risk to anyone trading at the time when the issue occurs. Can you argue that the problems will get fixed eventually? Yes, you can, but this is like saying if someone hacks into a database and takes information, will you in fact have any repercussions from this? It is not that clear if every single incident will be made whole and whether secondary effects may happen down the road. Furthermore, since all markets are related, should a technical glitch close down one market, related markets would be affected since all markets are designed to relate to each other by comparing them to find the best price. This is also known as arbitrage. Since technology allows this to happen quickly, if the technology is temporarily closed down or giving false prices, can this arbitrage really work the way it is supposed to work?

What are solutions to this problem? What used to happen with preventing failure of systems was that redundancies or secondary systems were built in that could seamlessly operate as well as the primary system. As an example, if one person was away, a second person of equal skill can takeover, and there would be no loss of time or output. This is not the case with the markets today. If the technology goes down, manual entry cannot keep up with the trading volume and the market would close down until the technology is fixed. If this was not true, you would not be hearing about these trading glitches, since they cause headaches for the entities concerned. Another solution would be to slow down the use of technology to allow multiple ways of doing a task. If you think technology is progress and can never be reversed, ask yourself this question: If you went down the wrong route to a destination, wouldn’t the best solution be to turn back and rethink where you are rather than trying to continue ahead and get more lost?

Sources:

1)                  http://www.bloomberg.com/news/2013-08-26/eurex-futures-exchange-halts-trading-on-technical-glitch.html

2)                  http://www.bloomberg.com/news/2013-08-26/nasdaq-three-hour-halt-highlights-vulnerability-in-market.html

3)                  http://uk.reuters.com/article/2013/08/21/goldman-options-review-idUKL2N0GM24520130821

4)                  http://money.cnn.com/2013/08/21/investing/goldman-sachs-trading-glitch/index.html

Effects of the LIBOR Scandal Still Smoldering

It is not a secret that the LIBOR (London InterBank Offered Rate) interest rate was tampered with and there were fines levied against some major banks. (4,5,6,7) Is this the end of the story? Even though the fines were large, and names were made public, the effects are still smoldering. The LIBOR rate affects many different interest rates that spawn over many financial contracts. The dollar amounts involved are in the hundreds of billions of dollars, and the number of players affected is large.

So what is coming next? There is a wave of lawsuits brewing in the courts concerning how institutions were affected by this tampering, and how much they should be compensated. It is assumed that the fines levied so far are only concerning the crime itself, and setting a precedent for future behaviour. The damages inflicted from such behaviour tend to get sorted out in civil court – or through lawsuits between the parties affected. This stage takes much longer, but the effects will have a much deeper impact. If you use a $100 billion notional amount as an example, and interest rates vary by 1% compared to what they should be, this is a $1 billion “damage claim” every year. Multiply this by 10 or 20 years, and make the $100 Billion amount equal to $500 Billion, and you are realizing how big these lawsuit amounts can be. There may also be secondary effects such as “if I had known the interest rate was 5% instead of 4%, this would have impacted such and such an investment decision, which would have lead to further losses”. This could be labelled as speculation – but if you have proof that this would have happened, who knows what the verdict will be? (1)(2)(3)

This LIBOR scandal is one of the biggest in history in terms of dollars and people affected once the damages have been sorted out down to the level of the common person. Has this issue been resolved by the regulators? It seems that the answer is a long time coming.

Sources:

1)                  http://www.ipe.com/guest/dutch-giants-apg-pggm-exploring-possibility-of-future-libor-claims_55888.php#.UhNrq3-0fN5

2)                  http://www.bdlive.co.za/world/europe/2013/08/19/investors-go-after-banks-involved-in-libor-scandal

3)                  http://www.businessweek.com/articles/2013-06-27/calculating-the-cost-of-the-libor-scandal-to-investors

4)                  http://www.telegraph.co.uk/finance/libor-scandal/9614822/New-laws-will-criminalise-Libor-manipulation.html

5)                  http://www.guardian.co.uk/business/2012/oct/15/rbs-suspends-trader-libor-investigation

6)                  http://www.ft.com/intl/cms/s/0/2a4479f8-c030-11e1-9867-00144feabdc0.html?goback=.gde_38535_member_128901063#axzz1zkCJ4kKc

7)                  http://www.delawareonline.com/article/20120717/BUSINESS05/307170040/LIBOR-flaws-allowed-banks-rig-benchmark-without-conspiracy?odyssey=mod|newswell|text|Business|s&nclick_check=1