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More Flash Crashes To Come As Shadow Banking Liquidity Collapses

Tyler Durden's picture




 
Remember the algo-ignited, six sigma anomaly that sent 10-year yields down 30 bps in seemingly no time flat on the morning of October 15? Well despite the CFTC’s contention that it was “just a high volume day” without “any break in liquidity,” the Center for Financial Stability is out with a new report which cites the Treasury flash crash as a glaring example of what happens when an increasingly illiquid market collides head-on with “herding investment behavior.” 
From the CFS: 
On October 15, the deepest and most liquid market in the world demonstrated a six standard deviation move in less than two hours, a move that happens once in 506,797,346 days! It is impossible to suggest that this supersized move in the US Treasury market was due to downward assessment of economic expectations. Economic expectations shift weekly – if not daily. Clearly, a shift in the structure of the US Treasury market and substantial reduction of private sector market makers is at the core of recent complications. Similarly, this issue extends well beyond simply the sovereign debt market for US securities, as a result of the interconnectedness among markets and the unique role for Treasury debt as benchmark securities. To be sure, a sustained “flash crash” in the world’s leading fixed income market could readily unleash a pronounced slowdown of the global economy, or worse. 
Put simply, excessive (and incessant) Fed meddling has fundamentally altered the market structure, creating all types of strangeness (the 2-, 5-, and 10-year all special for example) and in the process of sucking collateral from the system, the central bank has made things far more precarious. Recall what Bloomberg had to say about this back in October: 
The amount of U.S. debt available to trade at one time without moving prices as of October has plunged 48 percent to $150 million since April, according to JPMorgan Chase & Co.
As the CFS report goes on to point out, the lack of liquidity in the market is readily observable by way of data on various shadow banking conduits. Incredibly, liquidity has plummeted by nearly half since the eve of the crisis: 
...the reduction of market finance is excessively steep. The CFS measure of market finance is down a stunning 46% in real terms since its peak in March 2008! This phenomenon starves financial markets from needed liquidity and is detrimental to future growth by exposing the economy to potentially unnecessary shocks.
Even more alarming is the following table which shows that shadow banking has contracted for 82 consecutive months...
...and here’s Bloomberg again, with DB’s take: 
A Deutsche Bank index that gauges liquidity by the three-month average size of daily dealer transactions in Treasuries relative to the variability of the 10-year note yield during that period is down to a reading of about 25, from over 500 in 2005. The current level is close to the low of about 19 at the depth of the financial crisis in 2009.
The problem isn’t confined to government debt. CFS also notes that the veritable dearth of liquidity in the secondary market for corporate paper (presumably related to regulation ostensibly aimed at eradicating prop trading) could lead to an “accident”: 
...a recent report by BlackRock highlights how “the secondary trading environment for corporate bonds today is broken.” Data suggest that diminished corporate bond liquidity is in part due to limited participation by market makers. For example, debt holdings by primary dealers are down by 80 percent since a peak in October 2013. These examples signal that the probability of an accident is high and the stage is set for an adverse event meeting with an outsized impact on markets and possibly economies. 

We predicted this 18 months ago, when we warned that “the slightest gust of wind, or rather volatility, threatens to shut down the secondary corporate bond market, which already is running on fumes.”

Of course the last thing you would want to see in this type of environment is a scenario wherein non-human actors are all programmed to move in exactly the same direction at exactly the same time, thus exacerbating the already amplified (thanks to the illiquidity issue) impact of a market-moving event. Thanks to the rise of the machines (a fifth of electronically executed Treasury trades will be executed by robots this year), we have precisely that, as even the zen masters at Bridgewater are starting an artificial intelligence unit. As we noted previously, “it seems that everyone has forgotten [what happens] when all the machines chase down the same rabbit holes?”

Perhaps the ultimate irony in the whole thing is that a Fed policy (i.e. QE) designed explicitly to stamp out tail risk (i.e. a three standard deviation move), is beginning to create six standard deviation moves in the space of just hours. Throw in the unintended consequences of new regulations and a growing legion of lightning fast (if often hapless) robots and you’ve got the makings of a truly impressive meltdown.
 

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Sun, 03/01/2015 - 19:16 | 5843877 flacon
flacon's picture

Buy moar AAPL! 

Sun, 03/01/2015 - 19:33 | 5843927 philipat
philipat's picture

"the CFTC’s contention that it was “just a high volume day” without “any break in liquidity,”

Is this just more propoganda from another "Regulator" or does CFTC truly not understand the difference between volume and quotes?

 

Sun, 03/01/2015 - 19:46 | 5843951 NoDebt
NoDebt's picture

Water everywhere but not a drop to drink.

Remember the moves the prices of the asset are determined in the MUCH LARGER futures (and swaps) market, not in the cash market.  T'wasn't always so, but certainly is now.

Sun, 03/01/2015 - 21:05 | 5844166 barliman
barliman's picture

 

To rephrase this pedantic observation in the vernacular of these days:

Sudden, massive outbreaks of ASS RAPING will occur without warning!

Technical indicators, Elliot Wave Theory and hedge positions will providen insufficent "lubrication".

Please turn to the chapter on "Discontinuity" in your text books.

Mon, 03/02/2015 - 04:56 | 5844729 giovanni_f
giovanni_f's picture

For our masters, Big Government can divided into two categories. 1. Good big government (GBG) and 2. Bad big government (BBG). BBG is anything that protects us from them, GBG anything that protects them from us. Under Reagan, Clinton, Bush, Obama - no difference - GBG got a boost while BBG was reduced to a joke. You can design government agencies to become GBG by either making them toothless (CFTC), or by placing a bunch of cronies at the helm (SEC) or by a combination of the two methods.

The ultimate solution however is to give the Mafia the tools and privileges to "self-regulate", see (ISDA, derivatives) since the private sector is smarter at looting us.

Sun, 03/01/2015 - 19:24 | 5843898 disabledvet
disabledvet's picture

"Hey, Butch.  There's some guy outside the ISS banging on my window."

Sun, 03/01/2015 - 19:25 | 5843900 Thirst Mutilator
Thirst Mutilator's picture

6 sigmas bitchez!... 6 more to come... & 6 after that!!!

Sun, 03/01/2015 - 19:31 | 5843917 B2u
B2u's picture

Where can I get more SNAP cards?

Sun, 03/01/2015 - 19:50 | 5843964 GMadScientist
GMadScientist's picture

The Ghetto.

Sun, 03/01/2015 - 19:31 | 5843921 ah-ooog-ah
ah-ooog-ah's picture

Liquidity ?  we don't need no steeeking liquidity

Sun, 03/01/2015 - 19:42 | 5843946 GMadScientist
GMadScientist's picture

Next stop ABCP lock-up?

Sun, 03/01/2015 - 19:48 | 5843960 q99x2
q99x2's picture

No need to panic. Nothing a little FRAUD, printing and FED algo trading can't fix. BTFD

Sun, 03/01/2015 - 19:49 | 5843961 devo
devo's picture

This prediction, too, will be wrong.

Sun, 03/01/2015 - 20:17 | 5844034 rsnoble
rsnoble's picture

So there was a flash crash almost 1.4 million years ago? WOW, I need to go take a history class.

Sun, 03/01/2015 - 20:43 | 5844082 permarig
permarig's picture

The Oct 15 action was a kill job market manipulation at the height of the ebola craze (which also speaks about the ebola thing).
It happened in concert with USD/JPY (correlated with UST yields, stocks), oil and stock indices.

All correlated, to smash stocks down to the channel floor to be picked up by the insiders for the runup that was coming with the unexpected BoJ action in the pipeline (aka the Halloween Yen Massacre).

The Bullard soundbite then kicked it off.

https://pbs.twimg.com/media/B-zcLWBUEAAAlF4.png:large

NanexLLC's twitter feed posted metrics that in his read showed the same kind of HFT quote cancellation action that was also prevalent in early Feb 2014 when the S&P 500 made the low for the year.
I think he even said, that if it's the same thing going on again, we're in for a stock market surge. And now we see it turned out to be the case.

He also reported significant fake quote activity in the Russel 2000 (it got obliterated in October) in the afternoon just before it turned to rip into the close. This is also indicative of some kind of shakeout algo action.

 

Sun, 03/01/2015 - 21:02 | 5844158 847328_3527
847328_3527's picture

Money supply velocity has to be near zero for the Middle Class.

Sun, 03/01/2015 - 21:06 | 5844171 barliman
barliman's picture

 

What is this "Middle Class" you speak of?

Sun, 03/01/2015 - 22:11 | 5844354 jldpc
jldpc's picture

You guys are wondering around in the dark. Here is what has and will happen:

Stock market goes to the moon on zillions of "new" printed paper money - merely book entries.

Fed buys up most all US Government debt instruments, makes federal deficit a negative interest "investment."

Bond markets loose most all liquidity - Fed never sells any of its  holdings.

Big scare is generated. I mean bib, big, big, big and even bigger. Stocks are sold like death is upon us all, and the money goes straight into illiquid US bonds.

Fed leaks out a few and squeezes out of all the panicky ones, most all of their money, and the FED makes a super big profit AND

Goodbuy Federal Deficit, hello sound super dollar, so let's have another WAR because we have good credit again-

Hell people pay the government to hold their money.

Nice huh?

Mon, 03/02/2015 - 03:13 | 5844877 AbbeBrel
AbbeBrel's picture

Hey if you are into probability (standard deviations and such) (I am) - here is an even neater report from WolfStreet / Dshort than usual :

http://wolfstreet.com/2015/02/25/this-is-what-overvalued-stock-markets-d...

I hadn't seen the analysis of how long things can hover over 2SD above the mean trend historically before. That is pretty cool. Sounds a lot like a Wile E Coyote moment (or month :-).

Also my favorite of Dshorts chartporn - looks like we are rolling over to me (scroll down to the NYSE Investor Credit and the Market graph):

http://www.advisorperspectives.com/dshort/updates/NYSE-Margin-Debt-and-t...

Good luck out there...

Mon, 03/02/2015 - 05:19 | 5844940 turnoffthewater
turnoffthewater's picture

Simple solution, Just print moar

Do NOT follow this link or you will be banned from the site!