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from Eric Burroughs:

Warning signs on market liquidity risks

If the great commodity selloff of 2011 shows nothing else, it is that markets are undergoing serious structural changes that need to be followed closely. Our commodities analyst John Kemp has compared the oil plunge with the May 2010 flash crash in U.S. shares, and rightfully so. Four standard deviation moves in oil futures are not normal, even if Gaussian distributions underestimate the chance of such a move. The rise of high-speed electronic trading appears to be creating imbalances between buyers and sellers in nanoseconds that lead to outsized moves. It would probably be manageable if these problems were tied to smaller markets not so correlated with the rest of the world. But in this age of highly correlated global markets, these changes matter and need to be better understood -- both by market participants and regulators.

One curious outcome about the rise of algo-driven trading is the volume is not leading to better liquidity, especially in these flash crashes. Liquidity -- defined as the ease with which trades can take place without causing a major price  impact (and not referring here to overall bank liquidity/funding risk) -- appears to suddenly vanish in some of these big market moves, leading to massive swings.

Liquidity is a fundamental part of market dynamics -- how to think about where to buy and sell -- and is almost always at the root of market stress. On a day to day basis, the dynamic is fairly natural. Traders closely follow chart levels, such as Fibonacci retracements, in part because stop-loss orders can accumulate around those levels, leading to sudden lurches -- a relatively illiquid imbalance in trading as the burst of selling pushes bid/ask spreads wider. Such moves can define the trend of the day, change the near-term trend or even the long-term trend when they strike at a crucial moment. There's no doubt that old-fashioned leverage, stop-losses, option-related gamma selling and the sort played a role, as our Reuters special report fleshed out. Yet those factors still do not explain some of the severe intra-minute and intra-hour volatility.  There is nothing normal about these new kind of market moves. As much as bubbles are normal, and silver looked bubbly, there was no reason why the silver selloff should have had a bigger impact on oil than gold -- and expose weaknesses in the trade of WTI and Brent futures, even with the leverage that had built up in those markets. Leverage alone does not explain this new brand of chaotic market swings.

There's a few ways to guess what happened here. One is that algo-driven selling dominated to the point that it overwhelmed buyers and potentially even led other players to pull bids. Computers created the two liquidity crises the SEC described in its report on why the Wall Street flash crash unfolded the way it did, with the hectic HFT trading prompting bids to be pulled. As the SEC described it: "This sudden decline in both price and liquidity may be symptomatic of the notion that prices were moving so fast, fundamental buyers and cross-market arbitrageurs were either unable or unwilling to supply enough buy-side liquidity." A perfect recipe for a price vacuum and severe downdraft.

What it suggests is that the computers are not providing liquidity, and in fact may be pulling liquidity in nanoseconds at just the time it is most needed. Air pockets seem to develop, leading to a flurry of offers and thinning bids -- and that's when the moves are the most severe. In the past year, flash crashes have now happened in benchmark U.S. equity indexes, oil futures and even dollar/yen (when the plunge to record lows happened on heavy structured product hedging in the least liquid hours of global FX trade). What happened to market makers? That's a question that needs to be answered. It appears that computers are reading computers, knowing when others are pulling back and prompting other funds/banks to do the same (not to mention the occasional runaway algo).

Why so? This may be the impact of liquidaty-adjusted value-at-risk gauges, otherwise known as LVaR. LVaR makes a lot of sense: you want your trading desk and portfolio risk to be judged not just on standard deviations of volatility, but to also factor in market liquidity on the price at which you might be able to sell since VaR is all about minimizing potential losses. On a basic level, LVaR can incorporate unusual changes in bid/ask quotes -- using standard deviations on mean bid/ask spreads -- to give risk signals. The further the mean bid/ask spread from the mean, the more dangerous the market conditions.

from Commentaries:

The VaR cover-up

By Pablo Triana

Pablo Triana is the author of Lecturing Birds On Flying: Can Mathematical Theories Destroy The Financial Markets? The views expressed are his own

Last month, several men and women assembled in a somber room in Washington to discuss one of the key issues (in my opinion, the key issue) behind the financial crisis that has caused so much misery.

Among those gathered were leading politicians and top financial professionals. A world-renowned bestselling author was there, too. You might think that the media would have devoted attention to such an important event. Surely journalists wouldn't want to miss the opportunity to report on a roundtable of policymakers and experts that promised to tackle the true factors behind the mayhem, right?

Wrong. The historic hearing convened by the House Committee on Science and Technology on the responsibility of mathematical model Value at Risk (VaR) for the meltdown has received essentially no coverage. A couple of informed bloggers here and there have shared the news, but the silence from the mainstream behemoths has been deafening.

This is outrageous. Bluntly stated, you can't talk about this crisis without talking about VaR. Can you imagine a reporter covering the fraudulent accounting crisis that afflicted America a few years back and not covering the Enron hearings on Capitol Hill?

The silence by the media when it comes to VaR has been accompanied by silence from policymakers and bankers. The former (with the notable exception of the FSA of Britain) may understandably wish the debate not focus on how badly a tool they wholeheartedly embraced for years has performed. And the latter (some of them at least) may resent the badmouthing of a tool they themselves invented and that has worked wonders for many a trader.

from Commentaries:

Goldman, liquidity and VAR

Goldman Sachs' second-quarter earnings release showed a continued increase in the amount of market risk held on the firm's trading book. Its risk appetite has continued to expand at a time when extreme turbulence has forced others to scale back.

True, Goldman's publicly reported figures may overstate its actual positions. But the Wall Street bank also appears to be taking advantage of its access to liquidity from the Federal Reserve to increase risk.

Total value-at-risk (VAR) averaged $344 million, on a gross basis before diversification effects, up from $303 million in the second quarter of 2008 and $226 million in the second quarter of 2007. 

Click chart to enlarge in new window.  Additional data available here.

(VAR is a crude measure of the worst loss the firm would expect to report on 19 days out of 20, given prevailing volatility in the market.)

Like other banks, Goldman reports VAR on a net basis after taking account of a "diversification effect". The diversification effect reflects the fact that risks in different parts of Goldman's book are not perfectly correlated.

The bank would not expect to lose the maximum amount on all its positions at the same time. So net VAR for the book as a whole is less than the sum of the VARs for the individual components (which Goldman reports as currencies, interest rates, equities, and commodities). Goldman's net VAR in the second quarter averaged $245 million, up from $184 million in the second quarter of 2008 and $133 million in the second quarter of 2007.