CME: Your overreaction isn’t my problem

Derivatives are really exciting and dramatic these days! Well, at least they’re exciting and dramatic if you study derivatives and are already interested in them, as I am. If you’re a normal person, they’re probably just slightly interesting at the moment. Or slightly infuriating, if you believe the bad press about them.

But even that’s something, because the world of derivatives – futures, options, swaps, etc. – seldom seems anything but arcane, dull and as boring as a banker. But in these post-crash days, even bankers have become exciting and they’ve brought derivatives along with them to the party.

It’s not for happy reasons, of course. Many people blame bankers and their use of exotic derivatives for the crash itself. Personally, I think the bankers and their opaque derivative arrangements were more a symptom of a cross-society mania, one that believed that we could engineer an end to risk,  than they were the cause of it, but what do I know? But there’s no question everyone in Washington, in the world’s financial communities and even in the general public seems to be talking derivatives. Even the local Winnipeg Free Press had a story on derivatives this weekend.

Today a number of derivatives biggies are going to be grilled on Capitol Hill in Washington about the role that derivatives might have played in the May 6 sudden crash and rebound that knocked the Dow Jones Industrial Average down – at one point – more than 800 points in less than an hour. Particular attention is being paid to the role of E-mini S and P 500 futures on the CME. These are a futures contract on the main Standard and Poors U.S. stock index and they are extremely well-traded and first showed the signs of the collapse coming on May 6.

The reason I’m writing about this is that the CME – which owns the CBOT – runs all the main North American agriculture futures and options contracts, from soybeans, corn, oats and winter wheat to lean hogs and live cattle, so whatever weaknesses run in one of its big contracts or with the exchange itself could affect the ones that prairie farmers rely upon for crop price discovery. We don’t want the CMEGroup to have unrecognized serious problems inside its contracts or systems that could whipsaw farmers and ag commodity traders the way that holders of Proctor and Gamble, 3M and Accenture were slapped about. (At one point Accenture had fallen by more than 99 percent, something that hurt a bunch if you had sell stops that were triggered in the slide, especially since it recovered most of the loss within minutes.)

The big problems were at stock exchanges around the United States, not at the CME, but the CME’s in the spotlight because e-minis either revealed the developing problem first, or caused it. The exchange would – and does -argue the former. Derivatives-haters finger the latter. (By the way, you’ve all heard the early theory that a trader with a “fat finger” caused this problem, right? That’s the theory that says a trader accidentally entered an order to sell a billion shares of something rather than a million, mixing up the “m” and the “b” keys on the computer or having his big, fat finger hit both at once, causing the “b” to be the one officially entered. My computer keyboard suggests such a fat finger would in fact cause an “n” to be depressed – that’s the key between the “M” and the “B” – but that’s not the point. Well, there’s not only no evidence that a “fat finger” caused this problem, there’s lots of evidence that nothing of the sort occurred. There goes another popular myth everyone loves . . . )

If you want to read an extremely well written and informative defence of the CME’s S and P E-minis and their role in the crash, read this report the exchange put out four days after “The Incident.” Here’s the url for the report on the CMEGroup page: http://www.cmegroup.com/files/May-6-2010-Incident.pdf

It’s also a nice defence of the role of index futures and a bit of a knock on another form of equity index product – SPDRs. (Standard and Poors Depository Receipts – exchange-traded funds that also follow indexes.) And it’s a fascinating insight into how derivatives and stock markets interact. I wasn’t joking when I said this was good reading. I don’t know how the writer did it, but he made a stunningly complex interaction of futures, ETFs, stock exchanges and various circuit breakers and other exchange systems make sense in a way that told the story of The Incident and that made an argument in defence of the CME. Like anything, you shouldn’t take the CME’s word as the only word on this story. I read a Wall Street Journal story yesterday that blamed the beggining of the cross-exchange slide on a very large sell order of e-minis placed by one Kansas City outfit, but even if that’s true, it doesn’t seem to challenge the CME’s assertion that the meltdown in stock prices at stock exchanges can’t be directly blamed on anything with the e-minis, because they declined less than 10 percent. If I can put words in their mouth: your overreaction isn’t my problem.

I’m going to be interested in what I hear from the derivatives luminaries today. Since this is political, it’ll probably be a lot of dramatic but useless moralizing by left and right trying to get out in front of the wave of generalized outrage with the financial industry. But if they can make the situation – at least the derivatives bit of it – anywhere near as clear as the CME piece makes it, they’ve achieved the almost-impossible, and made derivatives interesting for a day.

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