Comment by csomar | Hacker News Reader

Comment by csomar | Hacker News Reader

Most people are missing an important point. From FT Website:

> That prompted Nasdaq to cut the entire trade on Wednesday and the exchange confirmed that the loss accounted for all of the exchange’s own default fund of €7m and swallowed €107m, or two-thirds, of its €166m mutual default fund that clearing house members must contribute to.

So a single, one person trader was able to basically bankrupt the Nasdaq insurance fund. This fund is supposed to cover all of the margin trading misfortunes but a single guy/position took it all away.

This means that the Nasdaq (and probably any other exchange) is not ready for a volatility event. In the case of extreme volatility, the Nasdaq insurance fund will be 0. Counterparties in derivatives won't get paid, and potentially the mutual funds/etfs/other structures depending on these derivative trades will collapse.

The next financial crisis is just one trade away.

Edit: re-reading and searching further, it looks like the fund that was depleted was not that of the Nasdaq but rather a mutual fund for several exchanges. The Nasdaq had only 7m euros. What a joke.

> This fund is supposed to cover all of the margin trading misfortunes

The fund is a first line of defence once a member’s assets fail to cover their exchange obligations. It is intended to quickly deliver capital to avoid market disruption. After that, there is a waterfall [1] which essentially comes down to Nasdaq’s members footing the bill.

Mutualised losses were the original model. It took time to activate, however, which in a T+1 or 2 settlement world is likely to cause = disruptions. The fund was implemented to provide a fast intermediate short-stop for medium-sized (i.e. big, but not systemic) losses.

The system worked as intended, today.

[1] https://business.nasdaq.com/trade/clearing/nasdaq-clearing/r...

This is peanuts and the system worked as intended against single investors not able to clear. It's the systemic risk that causes large crashes.

Systemic risk comes from a instrument that creates instability and flies under the radar. You can't get solid statistics to estimate the risk for the system as a whole, but everybody is doing it. It's usuaully good idea in microlevel but when everybody does it for leverage, it becomes a systemic risk.

Today margin debt – investors borrow against their portfolios – creates liquidity out of nothing. Securities based loans (SBL's) aka "shadow margin" is the most likely suspect for the next market crash. Brokerage firms entered the leverage markets the same way insurance companies did in 2000's

When you have lots of assets, you can take a loan using them as collateral, typically 70-80 percent. That type leverage has provided massive profits in the last 10 years.

Property markets are also connected to shadow margin. Million dollar apartment in San Francisco allows investors to save their cake and eat it too. They bought property and invested in the markets at the same money. When property values increase, there is more money to invest in stock markets. When the the value of stock portfolio increases, there is more money to invest in the stock market.

It goes up and up until there is perturbation that causes margin calls. Margin calls cause prices to drop and they lead to more margin calls and investors are forced to sell. Then enough people have to sell their properties to cause property values to drop and more margin calls follows.

You're saying he traded directly with Nasdaq, not through a prime broker or corporate entity?

For your average reader, most funds don't have an account directly with the exchange. They go to a Prime Broker such as GS, JPM, MS, etc, who keep an eye on the exposures of their accounts and limit what orders can go into the exchange. So for instance I ran a couple of hedge funds, and we'd get risk reports from the PBs which told us how much they were willing to let us trade. Also they'd do things like allow you to cancel risks across accounts if you owned a stock in one place but were short another. And they'd have risk models that looked at how correlated your positions were.

Now that's not to say that Nasdaq can then just be reckless, but normally the PBs are very large banks that have capital requirements, and even if things go badly, chances are someone will decide they're too big to fail.

PS. This PB thing can go wrong as well, but the idea is there's a degree of containment and incentive to keep things sensible. The senior guy at one of my PBs was fired because he allowed an Arab sheikh to gamble with too much leverage, and the sheikh lost hundreds of millions and ate up the bank's capital. (You're supposed to ask for enough margin that you don't lose your own money.)

As I understand it, he was such a big player that he didn't need a broker / basically was a broker himself.

Yes, as I also understands it he was a direct member of the exchange. When this happened he owned 23 Twh of nordic and 11 TWh of german power derivatives contracts. That is 1/4 of Norway's consume in 1 year: https://www.hegnar.no/Nyheter/Energi/2018/09/Derfor-tapte-Ei...

He basically did become to big for the marked.

This makes me scared too. When a single guy's positions can wipe out two thirds of the obligatory default fund, it seems to me that there is a mismatch between the risk allowed taken by exchanges and the amount of money they have to put towards the fund.

That us a fantastic point. When real problems occur they will be measured in the billions not a couple million. Clearing houses are expected to handle counter party risk but this event makes it clear only bailouts could handle a true crisis.

I wouldn't exaggerate the impact though. The financial impact to the derivative counterparties would be only by how much the market moved since their last collateral call. The impact of not being paid that movement on the ultimate consumers of these derivative shouldn't be huge. All it means is that they have a naked commodities, equity, interest rate or fx position when they were hedged before.

The systematic risk I assume must be more around the financial stability of the intermediaries who have large matched position but can't survive a large directional movement should there be a mismatch. I am thinking brokers, leveraged hedge funds or investment banks.

On Jan 15, 2015, the Swiss Franc was de-pegged, and several large brokers went more or less bust. Some of the biggest banks got stung badly.

The damage happened largely because in-the-red smaller traders couldn’t meet their margin calls, so the bigger parties took the hit. I see no reason that an event just 10x as bad couldn’t have bankrupted the big players.

https://www.irishtimes.com/business/personal-finance/traders...

Apparently, based from the comments, it was because he could clear his own trades

Clearly he couldn't. Not only that but the whole Nasdaq and other exchanges (mutual fund) struggled at doing that. Something is wrong.

Well, that's the point -- he couldn't. He was also trading from a personal account it seems. Seems a bit odd they would allow that.

The rules also allowed a single trader to own 25% of the marked[0].

0: In norwagian: https://www.dn.no/nyheter/2018/09/14/1431/Finans/-einar-aas-...

Futures is not quite the same as 'owning' the market/asset...

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