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A Trade for Millennium Jitters

By Andrew Webb

To most traders, Y2K is something that the IT department frets over, not a trading opportunity. However, Frederick Sturm, first vice president at Fuji Securities, is proposing a couple of trades designed to create an upside for the millennium. Former colleague Gabe Pentelie originally raised the idea with Sturm, who then converted it into a few concrete millennial trade suggestions.

The underlying justification for the trades is that investors may express their aversion to Y2K computer snafus by moving money out of deposits in software-laden banks and into fixed-income securities, such as Treasuries or bearer paper. This could put a squeeze on bank liquidity and drive up money-market rates in December 1999, relative to levels in either September 1999 or March 2000. To take advantage of this spike for the eurodollar, Sturm is recommending selling two December ‘99 eurodollar futures and buying one each of the September ‘99 and March ‘00 contracts.

“If you analyze the performance of a year-end ‘butterfly’ over the last 10 years, you can see that, with six quarters to expiry, you have a 90 percent confidence that it will be priced between one tick and 15 ticks,” says Sturm. “By that stage this year, however, the millennium eurodollar butterfly was trading at 18 ticks, which you can approximate as the price tag that the market is putting on the potential financial disruption of Y2K.”

The euroyen “dragonfly” follows a similar script, but has a “condor” body (selling one each of the December ‘99 and March ‘00 euroyen and buying one each of the September ‘99 and June ‘00) to take into account one additional factor—that the Japanese fiscal year-end is March 31, not December 31. While that may reduce the chances of technological mayhem in Japanese banks on January 1, 2000, it will leave them vulnerable until the end of the first quarter of 2000. The icing on the cake with this trade is that Japanese banks are relatively underinvested in technology, especially when compared with Japanese industry, and are seen as prime candidates for serious Y2K problems.

To date, the trades have been popular with some larger players, who have put them on in size. Interest has been particularly high with trading managers at swap warehouses who have the elbowroom to make proprietary trades. “That’s to be expected from people who are constitutionally involved in the term structure of Libor anyway and are always looking for anomalies or opportunities in forward Libor or in eurocurrency,” says Sturm. “The other interest group has been the proprietary trading desks at commercial banks and investment banks.”

Sturm stresses that these are long-term strategic trades, requiring a longer-term trading approach. “The objectives here are modest, and you’re not likely to gain much by slinging them around and getting impatient,” he warns. “They probably won’t appeal to those traders reared on quick in/out trades such as the two-year Treasury-eurodollar spread in the eurodollar, where you can get in and out in five minutes flat.”

Although the eurodollar “millennium fly” took off pretty smartly in March and quickly exceeded the 90 percent confidence range’s upper boundary, it has since drifted back and currently looks cheap at a credit of 17 ticks (the upper boundary is currently in the neighborhood of 27 ticks). The euroyen dragonfly has taken off more slowly, probably as a result of the thinner liquidity in the back months of the futures contract. It is currently hovering inside the upper boundary, and still looks like a strong buy at that level to Sturm. “Considering the rarity of millenia, it’s a fair surmise that these trades are only fairly valued once they exceed that upper boundary—at least until participants have concrete reason to change their minds about the cost of Y2K disruption,” he says.

eurodollar “millennium fly”
Fuji’s eurodollar “millennium fly” trade is a bet that money will move from banks to government securities to avoid Y2K glitches. This chart shows a 90 percent confidence range for this trade based on the last 10 years’ history. The thicker black line shows how the trade has behaved to date.

Elbow Risk

By Nina Mehta

Everybody’s heard of rogue traders, but rogue body parts haven’t quite made into the financial literature. Until now.

On the afternoon of July 23, a Salomon Smith Barney trader in London placed an order to sell 100 10-year French government bond contracts at market on Matif’s electronic trading system. Not realizing that his keyboard’s F12 key had an instant sell feature, he later inadvertently repeated that order 145 times when he leaned his elbow on the keyboard.

The price of the 10-year French government bond dropped 1.4 percent in a matter of minutes, surprising traders and Matif’s monitoring staff on an otherwise unremarkable day. The price drop almost reached a “limit down for the day,” says a source at the French exchange. Each contract was worth 500,000 francs ($83,600), and 10,607 of the contracts were matched by counterparties before trading was halted.

Minutes after the sell orders were placed, Matif officials noticed the unusual spike in volatility and traced the orders to Workstation 201 at Salomon Brothers’ London office. When the Matif called to confirm the orders, Salomon initially denied placing them.

A three-month independent audit conducted by CAP Gemini and Kroll Associates determined that the “disputed trades arose as a result of the prolonged, unintentional and inadvertent operation of the ‘Instant Sell’ key by a Salomon trader, and furthermore were not the result of faulty hardware or software.”

So was this an act of extreme carelessness? Not really. The Salomon trader, whose name has not been disclosed, did not know about the F12 key’s instant sell functionality. The company’s electronic trading desks had been installed with GL Trade software less than two weeks earlier, but neither the training manual nor a training session had mentioned the F12 feature. GL Trade is a Paris-based developer of software that links traders to electronic exchanges and enables them to enter orders. The investigators’ summary report notes that the company had released a new version of the soft- ware, “to prevent errors due to the ‘double F12’ functionality”—but had sent the earlier version of the software to the Salomon office.

Salomon asked Matif to cancel the trades but Matif declined, deciding to stick to its market rules. In the first place, an exchange official notes, both parties have to agree to the cancellation of the trades—and in this case, few counterparties did. In addition, the trades were not what the exchange refers to as a “manifest error”—that is, says the official, “a very gross error,” such as keying in an order for 5,000 contracts rather than 50 contracts. In the July case, it couldn’t be established that what had happened was different from a natural “market phenomenon.”

Matif says it was gratified by the independent investigators’ findings for a couple reasons. After the July spike in volatility, traders and others had called into question the exchange’s electronic systems. There was speculation that someone might have infiltrated the computer system and changed an order. There was also fear that the software source code housed a bug, or that a bug had been introduced into the system. “All sorts of things have been said,” notes the official. “That’s why the results of this audit are important to us.”

…And Order-Routing Risk
A keyboard error of another kind caused momentary chaos in the Chicago Mercantile Exchange’s S&P e-mini system on Thursday, October 15, one day before the quarterly contract expiration.

When the Federal Reserve announced it had cut interest rates by one-quarter of a percentage point, the S&P e-mini futures quickly spiked 50 index points, pushing prices from about 1,025 to 1,075 in two minutes. As a result, a number of sell limit orders—a sale order with a maximum sale price limit—were cancelled, creating a momentary dearth of sellers in the system.

A glitch in the Merc’s TOPS order-routing system then played havoc with the market. Many firms that use TOPS to route e-mini orders into Globex2 specify a price limit of 9,999 ticks, a wildly unrealistic number that ensures that their market and stop orders will almost always be matched. When a trader mistakenly keyed in a ridiculously high buy market order, there were no sellers in the system for it to be matched against. A glitch in Globex2 caused the order to became a limit order bid at 9,999.75, the highest price Globex2 accepts.

The result: on seeing the massive limit order bid, a seller hit it, causing the trade to take place. That trade then triggered other buy stop orders, which also became limit orders to buy at 9,999.75, and those orders were also hit by sellers.

The contract settled at 1,062 that day, but at 3:30 p.m., after the close, the president of Globex2 announced that all transactions above 1,085 were null and void.

That decision caused some grumbling in the pit. “There should be some fail-safe mechanism,” says one local. “It makes us doubt whether we can use the e-mini in a busy market.”

The Merc is examining the problem. In the meantime, it recommends that all Globex2 users set realistic limit prices when entering market or stop orders.

Libor or Lie-Bor?

The London Interbank Offered Rates calculated by the British Bankers’ Association represent the most important market measures in the derivatives world. So it is surprising, and a little unsettling, that one of the most important Libor figures—yen Libor, on which billions of dollars in derivatives contracts are based—is thought by many to be wildly inaccurate.

Each day, the BBA asks 16 “prime” banks in London, “In your view, what is the offered rate at which deposits are being quoted to prime banks in the London interbank market?” in a number of currencies. The highest four and lowest four responses are thrown out, and the remaining responses are averaged to determine Libor for the currency in question.

The problem: the yen Libor panel consists of eight western banks with good credit ratings and eight Japanese banks with poor—and deteriorating—credit ratings. Banks with poor credit quality, of course, are forced to borrow at higher rates since they are viewed by lenders as risky. These days, “the western banks all quote at rates of around 25 basis points, while the Japanese banks quote rates somewhere on the order of 60 basis points to 70 basis points,” says a hedge fund manager. “So the BBA takes the average of two very disparate sets of numbers and publishes a rate of 43 basis points to 48 basis points.”

The upshot: contracts written against yen Libor are fraught with hefty basis risk. “Right now the difference is 20 basis points between what yen Libor should be and what it really is,” says the hedge fund manager. “People have no idea how egregious the situation could get, and basis markets have popped up in which speculators are betting on whether it will get worse or better.”

Some have even bandied about the possibility of market manipulation. “The Japanese banks on the Libor panel aren’t able to take deposits of other prime banks [on the yen Libor panel] because of their credit ratings, so their answers [to the BBA’s daily questions] are purely hypothetical,” says a trader. “And since many of the Japanese banks have assets indexed to Libor, they may be responding with artificially high rates to manipulate the setting.”

The BBA’s response? On October 1, it changed the criteria used to calculate Libor to “the rate at which [the contributor panel bank] could borrow funds, were it to do so, by asking for and then accepting interbank offers in reasonable market size just prior to 11:00 a.m.” A subtle change, it seems, since the composition of the panel remains the same. “It is unclear how bad the BBA will let this get,” says the hedge fund manager. “For instance, if the Japanese banks go bankrupt, will they still be in the poll? If Japanese banks don’t meet BIS [Bank for International Settlements] requirements and are prohibited from doing business in London, will they still be in the poll? There’s a momentum of inertia at the BBA, and keeping things the same seems to be the desired outcome.”

Charity Show: $1 Million and Counting

If a good deed is its own reward, then the more than 400 derivatives professionals at this year’s Off Balance Ball have a million reasons to celebrate. The annual charity event, held October 16 and sponsored by some 50 derivatives-related companies, raised more than $125, 000 to benefit City Harvest and Trail Blazers, bringing its five-year cumulative total to more than $1 million.

This year’s theme, Le Cirque Des Derivatives, garnered a pre-event write-up in the Wall Street Journal, and infused the festivities with a carnival-esque atmosphere, including contortionists, stilt-walkers, fortune tellers, caricaturists and fire jugglers. One lucky raffle player bugged out when she learned she won this year’s grand prize, a 1998 Volkswagen Beetle, donated by Barclays Capital and Chase.

Committee members: Renee Blady of AOC, Gail Carmody of Barclays Capital, Sarah Lee of Bear Stearns, Jim Ostrowski of Cantor Fitzgerald, Ralph O’meany of Cargill Investor Services, Jim Velsor and Bill Mansfield of CIBC Oppenheimer, Tom Dwyer of Fuji Capital, Vivian Siao of Goldman Sachs, Doreen Davidow, Lisa Dalmer of NationsBank, Tara Schoenberger of OpenLink Financial, Tara O’Leary of Santander Investment, Tony Fusaro of Tradition, and Kim Kassin.

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