Are US regulators blowing it … again

May 7, 2010

Karen Shaw Petrou at Federal Financial Analytics asks a good question:

Last Friday, we outlined the systemic-risk implications of the growing EU crisis. In the days that followed, LIBOR spreads tightened, funding dried up and our fears only rose. So, we were a bit surprised to hear a senior U.S. bank regulator tell a radio audience Thursday morning not to bother their heads about any prospects that the European crisis could wash ashore. That was, of course, followed in a few hours by a classic systemic-risk crisis on the exchanges. Was the U.S. regulator keeping the game-face on so as not to scare the children? Or, more worryingly, are U.S. regulators still unprepared for another bout of systemic risk, whistling in the dark much as they did when they told us that subprime-mortgage risk couldn’t spill over?

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A computer glitch, a fat finger is that the best analysis we can do? Though I doubt we can trace the transactions if they went through “dark pools” yesterday’s situation looks a lot like a program trading variation with sell and cancel orders to create massive liquidity then intiating buys on a variation of the following example of a gaming strategy:

Savvy traders can use information about your order to manipulate prices in their favor. Some of the most common gaming scenarios include:

Gaming by manipulating the stock price. This scenario is explained with the following sequence of actions:
Figure 3. Gaming with Fishing
How gaming happens: 1) The Information Leak (Fishing)- By selling a few small lots, a gamer determines that a passive buyer has placed a standing order in a stock 2) The Exploratory Maneuver – The gamer buys the stock rapidly in the displayed market and succeeds in moving the stock up. 3) The Hit – After moving the stock, the gamer sends a large sell order to the dark pool and sells at substantially higher prices than the price he started buying at in the displayed market. 4) The Reversion – In less then two minutes it is all over. Prices revert as the gamer stops supporting the market.

Dark pools are lucrative, and can be anonymous trades.
U.S. regulators are observers and will have a difficult time regulating what the “insiders” already know and have succesfully kept quiet. It feels like I sat down at the high stakes table in Vegas, not investing with firms that are concerned with my volatility objectives or financial goals.
See the following for a simple description of “dark pools”. GResearch_Toxic_Dark_Pool_070208.pdf

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