fear by taking into account the likely reaction ofother traders to large orders when they develop their trading strategies. An interesting example in this regard occurred in a series ofbond market trades executed by Citigroup during August 2004.
Electronic Trading Games: Citigroup Hits All Bids—August 2004In the space of 18 seconds between 10:28 and 10:29 A.M., on Monday,August 2, 2004, Citigroup sold €11.3 billion of eurozone governmentbonds on the MTS cash bond trading platform by hitting most of thebids that rival dealers were obligated to make.21 The amount sold byCitigroup equaled the average daily trading volume on the MTS trading platform. Around the same time, Citigroup sold approximately€1.5 billion of eurozone bonds elsewhere to bring its total bond salesto about €12.9 billion. Not surprisingly, Citigroup’s trade set off aeurozone bond market slide as competing dealers raced to dump theinventory they acquired or hedge it in the futures market. Theseactions helped to drive cash and futures market bond prices sharplylower. The markets’ reaction to the Citigroup trades was entirely predictable and, most likely, anticipated by the Citigroup traders.22A subsequent investigation by the United Kingdom’s FinancialServices Authority (FSA) showed that after putting on these positions, Citigroup was net short €3.8 billion. This position was coveredat 11:25 A.M. on August 2, 2004 at substantially lower prices. Again,the effects on the market were entirely predictable—namely, widerbid ask spreads, lower market depth, and lower trading volume on theMTS. Some dealers reacted by suspending their participation in theMTS trading platform. It should be pointed out that Citigroup is apart owner of the MTS trading platform along with other commercialand investment banks.Citigroup made an estimated $18.2 million from the varioustrades. Citigroup’s action was neither illegal nor against the rules of
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the MTS trading platform. However, it did exert considerable pressure on the MTS and anger many traders and the governments whosebonds fell as a result of Citigroup’s actions.The question naturally arises as to whether Citigroup’s tradesconstituted an attempt to manipulate the market in their favor. Thefacts are as follows. Citgroup acquired a significant long position inGerman government note and bond (i.e., bund) futures contractstraded on Eurex prior to the rapid fire sale. Indeed, Citigroup bought66,214 interest rate futures contracts on Eurex between 9:17 and10:29 A.M. on Monday, August 2, 2004, according to a subsequentinvestigation by the FSA. The interest rate futures contracts acquiredwere of various maturities. The FSA estimated the preceding futuresposition was equivalent to 55,000 bund futures contracts. The FSAnotes that bund futures prices rose from €114.25 to €114.61 while the5-year note futures (known as the bobl) rose in price from 111.06 to111.21. This caused a rise in the cash market prices of the corresponding bonds and notes.23Apparently, the intended trade by Citigroup was a basis trade—that is, a trade that attempts to profit from differences between cashand futures market prices. The FSA concluded that Citigroup did notengage in price manipulation butexecuted a trading strategy…which…caused a temporary disruption to the volumes of bonds quoted and traded on theMTS platform, a sharp drop in bond prices and a temporarywithdrawal by some participants from quoting on thatplatform.24On June 28, 2005, the United Kingdom’s Financial ServicesAuthority announced that Citigroup agreed to pay about £14 millionin fines (£4 million) and forfeited profits (£9.96 million). The FSAdetermined that while Citigroupdid not intend to disrupt or distort the market, [it violated]FSA Principles 2 and 3 by failing to conduct its business with
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due skill, care and diligence and failing to control its businesseffectively.25Although the FSA determined that Citigroup had not attemptedto manipulate the market, the German financial regulator, Bafin (i.e.,the Federal Financial Supervisory Authority or Bundesanstalt fürFinanzdienstleistungsaufsicht), disagreed at least with respect to Citigroup’s actions in German futures markets. Bafin argued that therewas sufficient evidence that Citigroup attempted to manipulate theEurex futures market. The prosecutor’s office disagreed and nocharges were brought by the German authorities for the Eurex bondfutures trades.The Citigroup bond trading episode illustrates how large tradesalone can act as a trading catalyst. But more important than size wasthe fact that the large trades occurred within a short period of time—18 seconds—and Citigroup knew, or should have anticipated, thelikely reaction of other market participants (i.e., the firms that suddenly acquired a large inventory of bonds that they did not want tohold). This example exemplifies the effect that large buy or sell orderscan have on market prices even in the absence of the arrival of newfundamental economic information.As already noted, Citigroup’s trades were neither illegal noragainst the rules of the MTS trading platform. However, collectively,it was a bad trade despite making over $18 million for the firm. Muchtrading is a repeated play game. The bond traders at Citigroup wouldlikely have to trade again with the counterparties to the trades itmade on the morning of August 2, 2004. These counterparties wouldlikely remember being disadvantaged by Citigroup for a long, longtime. In addition, the episode made the MTS a less desirable tradingplatform. Bid ask spreads widened, depth narrowed, and subsequenttrading volume declined. However, the most important trading errorthat Citigroup made was to offend the governments that regulate it.
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The Citigroup bond trades illustrate once again that it is important to anticipate the reaction of other market participants to a potential trade. It is also important to remember that trading is a game thatis often played repeatedly rather than for a single time. This affectshow a market participant will “play the game.” Finally, the Citigroupbond trades also illustrate an obvious but sometimes overlooked fact:that the real trade a party may be making may be a spread or basistrade rather than an outright trade.
Size Matters: March 1996 CBOT Wheat FuturesThe preceding example illustrates the impact that large trades canhave on market prices. Size matters. Of course, what constitutes alarge order depends upon the circumstances and the market. In somemarkets, a relatively small order can exert a substantial impact onmarket prices under certain conditions. One such market condition isproximity to expiration for futures contracts. An example of how acomparatively small order exerted an out-sized impact on marketprices occurred on the Chicago Board of Trade (CBOT) wheatfutures market on March 20,1996 when a single order of 80 contractspushed up March 1996 wheat futures by 49% in a matter of minutes.At the time, the cash market price for wheat was less than $5 perbushel. The price rose to $7.50 per bushel before closing at $6.40 perbushel, or up $1.33 for the day. The increase in price was not due tothe arrival of news (fundamental information or otherwise) but ratherthe resistance by locals to taking the other side of a transaction minutes before contract expiration.26 This was a bizarre event that did notreally affect the prices of deferred wheat futures contracts.27The CBOT wheat futures market is a relatively liquid market innormal circumstances. This example illustrates how sensitive futuresprices are to relatively small trading volumes near expiration due tomarket illiquidity. It also illustrates how market conditions (in thiscase, proximity to expiration and the concomitant reluctance of locals
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to enter a position that might result in taking or making delivery) canexert a large influence on the behavior of speculative prices.
Trade Execution MattersPerhaps the penultimate example of the impact of order size on market prices occurred on Thursday, October 22, 1987 when an order(attributed to George Soros) to sell 5,000 December 1987 S&P 500stock index futures contracts at the opening on the Chicago Mercantile Exchange resulted in a massive decline in S&P 500 stock indexfutures prices.28 The December 1987 S&P 500 stock index futurescontract had closed at 258.25 the day before, but sentiment turnednegative again by Thursday’s opening.29 Thursday’s opening range(202.00 to 195.00) was an exceptionally wide 7 points, or $3,500.Moments after the large sell order had been filled, the marketbounced back rising as high as 250.50 before closing for the day at244.50. (The closing range was 244.00 to 245.00.) An individual whowas fortunate enough to buy a single December 1987 stock indexfutures contract at 195.00 and who held it to the end of the day wouldhave made $24,750. The spectacular price action in the S&P 500stock index futures pit on Thursday, October 22, 1987 is described inthe following excerpt from the November 2, 1987 issue of Barron’s.…[A]fter a two-day rebound in U.S. stock prices, the psychology had turned bearish again. Reports circulated of largemargin calls. U.S. stocks had opened sharply down on foreignexchanges. Using Shearson as a broker, Soros apparentlydecided to pitch out his entire [5,000 futures contracts] position on the opening. On the bell, the Shearson floor brokerbegan offering thousand lots. The other pit traders, pickingup the sound of a whale in trouble, hung back, but circled theprey. The offer went from 230 down to 220 to 215 to 205 to200. Then, the pit traders attacked. The Soros block soldfrom 195 to 210. The spiral was ghastly. It was Soros’s block
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and not program trading that drove the futures to a cash discount some 50 points, or 20%, below the cash value of theS&P contract. The discount on the 5,000 contracts represented some $250 million. The futures fund manager coveredthere, as did a number of local traders who made millions offthe immediate snapback in price. The contract that dayclosed at 244.50, or some $222 million higher, based onSoros’s position. Soros’s loss from the previous day was estimated at more than $200 million.30This episode illustrates several points. First, the magnitude of thedecline in the value of the S&P 500 stock index futures contract fromWednesday’s close to Thursday’s opening was 21.8% to 23.8%,roughly the same size as the decline in the cash S&P 500 stock indexon Monday, October 19, 1987.31 Unlike Monday, October 19, pricesin the stock market did not fall very much—at one point, the December 1987 S&P 500 stock index futures contract was trading at a50-point discount to the cash index.32 Also, unlike October 19, pricesquickly bounced back after the large sell order had been filled. Simply stated, the large sell had about the same impact on market pricesas the Monday, October 19, 1987 market crash did except that it waslocalized to the S&P 500 stock index futures market and was shortlived. Second, the episode illustrates the importance of market conditions and sentiment. The large sell order probably would not haveexerted much impact on prices in a normal trading environment. As aresult, the execution of the trade was flawed. Third, the episode illustrates once again the game-like nature of trading. Recall that theexcerpt notes that the locals in the pit assumed that the large sellorder meant that there was a large trader in trouble and refused tobuy at the initially higher offers. It is important to point out that theoriginal long futures position was acquired the day before, perhaps ina single order, and that order did not drive prices substantially higher.Fourth, the episode illustrates that although the initially reported
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trading catalyst—a missile attack on Kuwait and negative commentsby market guru Robert Prechter—may have stimulated the large sellorder, it was a factor internal to the market—the belief that there wasa large trader in trouble—that precipitated the massive price declineand immediate bounce back.
Precursor to the 1987 CrashThe crash of 1987 (which is discussed in detail in the next chapter)took many investors by surprise. However, market participants got ataste of what it would be like earlier in the year during an especiallyvolatile session on Friday, January 23, 1987. In the space of an hour,the U.S. stock market as measured by the Dow Jones Industrial Average plunged 115 points, or over 5%, only to bounce back and thenclose down 44 points, or 2% lower for the day. Big Board trading volume set a record as over 302 million shares changed hands. The reasons for the sharp decline and volatility were not known. Manyanalysts attributed the volatility to computerized program trading.33The wide trading range on January 23, 1987 is depicted in Figure 8.3.The speed of the decline was apparent in the stock index futuresmarkets on the Chicago Mercantile Exchange and the Chicago Boardof Trade. The lower cost of trading on futures markets means thatfutures markets often lead the corresponding cash or spot market. Inthis case, the stock index futures market leads the stock market.The S&P 500 stock index futures contract, which is traded on theCME, was the most actively traded stock index futures market. It hada “nickel” tick, or minimum price move, at the time.34 Most of thetime, the S&P 500 stock index futures market moved a “nickel” up ordown. However, on Friday, January 23, 1987, the S&P 500 stockindex futures contract suddenly started to move in “dollar” or fullpoint increments rather than nickels—that is, $500 at a time.
250
2400.002350.002300.001/23/87
2250.002200.002150.002100.00
1/23/87date.open 2145.95date.high 2210.07date.low 2094.07date.close 2101.52
2050.002000.001950.001900.001850.002/2/87
Daily trading range of the Dow Jones Industrial Average from January 1, 1987 to March 31, 1987.
FIGURE 8.3
Harbinger of the crash? January 23, 1987.
3/2/87
TRADING CATALYSTS
1/2/87
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Many observers attributed the various intraday ups and downs inmarket prices to waves of program trading.35 Not surprisingly, majorprogram traders denied that program trading was the culprit.36 Program trading can itself be decomposed into various types rangingfrom any computerized program that generates buy and sell orders toprograms that specialize in index arbitrage (i.e., arbitrage betweenstock index futures contracts and a subset of the stocks that comprisethe stock index on which the futures contract is based). By far, thedominant form of program trading at the time was index arbitrage.Academic financial economists would generally argue that index arbitrage is stabilizing rather than destabilizing and would reduce ratherthan exacerbate volatility. Whether the proximate cause of the volatility was due to program trading is less important than the fact that thecause was internal to the market.The exceptional volatility on Friday, January 23, 1987 returned onMonday, October 19, 1987 when a more severe decline occurred. Theevents of January 23, 1987 may have had a possible precedent on September 11, 1986 when the Dow Jones Industrial Average suddenlyfell and closed down over 86 points, or 4.6%. Analysts attributed thatdecline to an external trading catalyst (i.e., adverse interest rate news)whose impact was exacerbated by an internal trading catalyst (i.e.,program trading activities).37
Trading LessonsInternal trading catalysts often exert a larger impact on market pricesthan external catalysts. A seemingly innocuous shock can precipitate alarge change in market prices in an environment where the tradingpositions of key market participants are both similar and concentrated by triggering positive feedback trading. In such an environment, it is imperative for traders to anticipate how key marketparticipants would likely react to a sudden internal or external shock.
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The most basic type of internal trading catalyst is order size.Large orders may exert pressure on market prices and influencetrader behavior as traders attempt to determine whether the partyplacing the large order has information other market participants donot. This was demonstrated in the Citigroup eurozone bond tradingexample. What constitutes “large” depends upon the particular market and other factors such as when the order is placed. A comparatively small futures trade executed near expiration can exert apowerful impact on market prices, as was shown in the CBOT March1996 wheat futures example.Equally important are the real and perceived positions of keymarket participants. If the market suspects a key trader is in trouble,prices often move in a direction adverse to that trader’s perceivedposition. This occurred during the Sumitomo copper debacle in 1996and in the yen/dollar market during September and October 1998when major hedge funds were rumored to be under pressure to exithuge short yen positions.The examples discussed in this chapter also demonstrate thatinternal trading catalysts can seemingly come out of nowhere toimpact market prices. Sudden changes in market prices for no apparent reason may be explained in many cases by internal catalysts.Another lesson that emerges is that although the impact of mostinternal catalysts on market prices is relatively short-lived, the impactof some internal catalysts on market prices can last a significant time,as the sharp appreciation of the Japanese yen against the U.S. dollarduring early October 1998 demonstrates. Finally, the impact of internal market catalysts on market prices can last even longer if theresultant price action changes market sentiment. Such effects arereadily observable in the aftermath of bubbles, corners, squeezes,and crashes, which are considered in the next chapter.
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ReferencesBarron’s. “A Bad Two Weeks—A Wall Street Star Loses $840 Million.” November 2, 1987.Collett-White, Mike. “Traders Count Cost of LME Copper Swings.”Reuters, June 7, 1996.CNNfn. “Tiger Wounded as Losses Bite.” November 2, 1998, 6:41A.M. ET.DeLong, B.J., A. Shleifer, L. Summers, and R.J. Waldman. “PositiveFeedback Investment Strategies and Destabilizing Rational Speculation.” Journal of Finance, Vol. 45, No. 2 , (June 1990a) pp. 379-396.DeLong, B.J., A. Shleifer, L. Summers, and R.J. Waldman. “NoiseTrader Risk in Financial Markets.” Journal of Political Economy, 98,(4), (August 1990b), pp. 703-738.Donovan, Patrick, Tony May, and Owen Bowcott. “Copper CrashBaffles Experts.” The Guardian, May 18, 1996.Dow Jones Business News. “Dollar’s Slump Leaves Japanese OfficialsPuzzled, Guarded.” October 9, 1998.Engle, R.F., T. Ito, and W. Lin. “Meteor Showers or Heat Waves?Heteroskedastic Intra-Daily Volatility in the Foreign Exchange Market.” Econometrica, Vol. 58, No. 3, (May 1990), pp. 525-542.Financial Times. August 10, 2004.Gooding, Kenneth. “Hedge Funds Blamed as Copper Falls 15% inTwo Hours’ Trading.” Financial Times, June 7, 1996.Gooding, Kenneth. “Commodities and Agriculture—HamanakaRumours Helped to Trigger Sales.” Financial Times, May 21, 1996.Hayes, Martin. “Sumitomo Copper Squeezes Date Back to Late1980s.” Reuters News, June 26, 1996.Holter, James T. “Case Closed? CFTC Nails Sumitomo with a $150Million Fine.” Futures Magazine. May 11, 1998.
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Houston Chronicle. “Wheat Futures Jump Nearly 50% to SetRecord.” March 21, 1996.Lenzner, Robert. “Don’t Blame Program Trading, Firms Say.” TheBoston Globe, January 27, 1987.Lincoln, Abraham. Letter to Albert G. Hodges, April 4, 1864.McMurray, Scott. “Chicago Merc Sets Daily Limit On PriceSwings—Aim Is to Reduce Volatility in Stock-Index Futures andOptions Trading.” The Wall Street Journal, October 23, 1987.McMurray, Scott. “Free Fall: Interest Rate Worries and ProgramTrading Send Stocks Plunging—Automated Selling GeneratesBiggest One-Day Decline as Volume Sets a Record—A Fluke or aPositive Omen?” The Wall Street Journal, September 12, 1986.Munter, Paivi, and Ivar Simensen. “Citigroup Eurozone Bonds PloyLeads to Panic and Clampdown on Trading.” Financial Times, August10, 2004.Pender, Kathleen. “‘Craziest I’ve Ever Seen’/Wild Trading Day forStock Market/Dow Goes Way Up, Way Down.” San FranciscoChronicle, January 24, 1987.Reuters. “Sakakibara Says ‘No Comment’ on Forex-Jiji.” October 8,1998.Reuters. “Asia FOREX-Withering Dollar Boosts Regionals.” September 7, 1998.Reuters. “Dollar Battered by Aggressive BOJ Action in Tokyo.” April10, 1998.Reuters. “Sumitomo Copper Losses Could Hit $2.5 Bln—Trade.”June 14, 1996.Reuters News. “Full Text of Sumitomo Corp. Statement.” June 14,1996.
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Rowley, Anthony and Neil Behrmann. “US$1.8B Loss at SumitomoRocks World Copper Market.” Business Times Singapore, June 15,1996.Siconolfi, Michael, Anita Raghavan, Mitchell Pacelle, and Michael R.Sesit. “Why a World-Wide Chain Reaction Set Financial Markets intoa Spin.” The Wall Street Journal, September 22, 1998.Sterngold, James. “Wall Street Day: Torrid Start, Sudden Chill.” TheNew York Times, January 24, 1987.The Wall Street Journal. Thursday, March 21, 1996.United Kingdom Financial Services Authority. “FSA Fines Citigroup£13.9 Million (€20.9mn) for Eurobond Trades.” June 28, 2005(http:/www.fsa.gov.uk/pages/Library/Communication/PR/2005/072.shtml).
Endnotes1
Abraham Lincoln. Letter to Albert G. Hodges, April 4, 1864.
2
Patrick Donovan, Tony May, and Owen Bowcott. “Copper Crash BafflesExperts.” The Guardian, May 18, 1996.
3
Patrick Donovan, Tony May, and Owen Bowcott. “Copper Crash BafflesExperts.” The Guardian, May 18, 1996.
4
Kenneth Gooding. “Commodities and Agriculture—Hamanaka RumoursHelped to Trigger Sales.” Financial Times, May 21, 1996.
5
Kenneth Gooding. “Hedge Funds Blamed as Copper Falls 15% in Two Hours’Trading.” Financial Times, June 7, 1996.
6
Large price changes make it difficult to delta-hedge option positions. Twoprominent banks incurred substantial losses from delta-hedging the copper putoptions they had written according press reports.
7
Mike Collett-White. “Traders Count Cost of LME Copper Swings.” Reuters,June 7, 1996. The article notes: “… ‘The delta on these options may have onlybeen 10 percent before the market crashed, but it got to fifty or even sixty percent,’ one trader said.”
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8
The text of the company’s announcement indicated that “[t]he Company firstdiscovered evidence of the unauthorized trading activities on June 5, 1996.” Theannouncement also noted that “[p]reliminary estimates indicate the possible lossthat the Company may have to absorb is approximately $1.8 billion, based oncurrent copper market prices.” Reuters News. “Full Text of Sumitomo Corp.Statement,” June 14, 1996.
9
Reuters. “Sumitomo Copper Losses Could Hit $2.5 bln—Trade.” June 14, 1996.
10
Anthony Rowley and Neil Behrmann. “US$1.8B Loss at Sumitomo Rocks WorldCopper Market.” Business Times Singapore, June 15, 1996. The article providesmore evidence for the game-like nature of trading when it notes: “Sumitomoholds long positions in copper and is widely believed to have been involved in aprice tug-of-war with major [hedge] funds … which decided to short the market.”
11
Martin Hayes. “Sumitomo Copper Squeezes Date Back to Late 1980s.” ReutersNews, June 26, 1996.
12
James T. Holter. “Case Closed? CFTC Nails Sumitomo with a $150 MillionFine.” Futures Magazine, May 11, 1998.
13
Reuters News. “Sakakibara Says ‘No Comment’ on Forex-Jiji.” Thursday, October 8, 1998.
14
Dow Jones Business News. “Dollar’s Slump Leaves Japanese Officials Puzzled,Guarded.” October 9, 1998.
15
Reuters. “Asia FOREX-Withering Dollar Boosts Regionals.” September 7, 1998.
16
Michael Siconolfi, Anita Raghavan, Mitchell Pacelle, and Michael R. Sesit. “Whya World-Wide Chain Reaction Set Financial Markets Into a Spin.” The WallStreet Journal, September 22, 1998.
17
CNNfn. “Tiger Wounded as Losses Bite.” November 2, 1998, 6:41 A.M. ET.
18
Academic thought on positive feedback trading has been strongly influenced bytwo articles by Professors Bradford DeLong, Andrei Schleifer, Lawrence Summers, and Robert Waldman that were published in the Journal of Finance andthe Journal of Political Economy in 1990.
19
Extrapolative expectations refer to forming expectations about the future assuming that the pattern of recent price changes continues. Positive feedback tradingpersists because various impediments to learning slow the speed at which marketparticipants learn.
20
Volatility spillover is the tendency for turbulence in one market to spill over toanother market. It is related to contagion risk. Correlation is a measure of howclosely two variables move together. Sometimes, two (usually unrelated) variables (e.g., silver and sugar) move closely together for a short period of time.This is known as transitory correlation. Illiquidity refers to markets where it isdifficult to buy or sell a large quantity without adversely affecting the price.
21
MTS SpA runs a trading platform for the electronic trading of eurozone bonds.
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22
Paivi Munter and Ivar Simensen. “Citigroup Eurozone Bonds Ploy Leads ToPanic and Clampdown on Trading.” Financial Times August 10, 2004, p. 1. Thearticle notes: “…Traders said the Bund futures contract on Eurex, the mainhedging instrument for eurozone government bonds, fell about 20 ticks in 30seconds compared with a typical daily move of only a few ticks. [Each tick has avalue of €10.]”
23
Financial Services Authority. “Final Notice to Citigroup Global Markets Limited.” June 28, 2005 (http://www.fsa.gov.uk/pubs/final/cgml_28jun05.pdf)
24
United Kingdom Financial Services Authority. “FSA Fines Citigroup £13.9 million (€20.9mn) for Eurobond Trades.” June 28, 2005 (http:/www.fsa.gov.uk/pages/Library/Communication/PR/2005/072.shtml).
25
Ibid.
26
The Wall Street Journal. Thursday, March 21, 1996.
27
Houston Chronicle. “Wheat Futures Jump Nearly 50% to Set Record.” March21, 1996, p. 3. The article notes that wheat futures for delivery during May 1996closed up 6 cents per bushel for the day.
28
Barron’s. “A Bad Two Weeks—A Wall Street Star Loses $840 Million.” November 2, 1987.
29
The article notes: “…[T]he pit was deluged with sell orders when tradingresumed [Thursday], forcing the contract down more than 60 points within seconds. The sell-off was tied to a missile attack on a Kuwaiti oil facility, and negative comments from the widely followed market technician Robert Pre