Communications Breakdowns

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Aug 3, 2012 12:30:31 PM

and tagged Yesterday's News

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The latest financial market glitch leads the papers today. The problems generated by Knight Capital with its new and undertested trading program rattled the markets, raised systemic questions, and may well have killed the company. The Financial Times (FT) focuses on the firm with “Software glitch leaves brokerage Knight nursing loss of $440M,” while the New York Times (NYT) takes two looks at the revealed risks with “Errant Trades Reveal a Risk Few Expected” on the front page and “An Automated Jolt for the Markets” on the front business page. The Wall Street Journal (WSJ) is relatively restrained, with the headline “Loss Sweeps Trading Firm” on the front page.

The consequences to the firm, in the end, will not matter to the markets. The consequences of the systemic risks that were revealed, however, are a lot more important. I have to say that this gets back to the issue I discussed in the “Taking a Ferrari into the Back Country” post regarding how we have optimized the system. Knight was clearly focusing on speed to deployment and optimizing for speed under competitive pressures, rather than optimizing for robustness. If every piece of the system is like this, small wonder it is fragile. Every event like this makes it more important to optimize for robustness—or at least introduce it into the discussion.

Speaking of fragility, the markets got hit hard by the clarification the president of the European Central Bank (ECB) made to his earlier comments that the ECB would do whatever it took to support the euro. Although it was generally interpreted to mean that the ECB would actually do whatever it took, what Draghi actually meant, after consulting with the Germans, was that the ECB would consider further action at the appropriate time—in other words, not now, but after the governments start spending their own money. This hit the markets and then the front pages—the FT has “Draghi kills hopes of instant ECB action,” the WSJ has “Europe’s Bank Rattles Investors,” and the NYT’s business section has “A Lofty Vow Falls Short, and Investors Show Dismay.” Investors took a look at the revised meaning of “whatever it takes” and decided they would take their money off the table.

On the good news side, the NYT and the WSJ, both on page B3, have stories about how U.S. retailers’ sales beat forecasts overall. Never count the American consumer totally out. I expect this trend to continue as real incomes continue to increase.

On the keep-an-eye-on-this front is the NYT story “Buried in Details, A Warning to Investors” on page B1, which talks about the conflicts of interest between the bank that created a financial product and the investors, and whether the conflicts were adequately disclosed. Like the story last month about whether J.P. Morgan was pushing its own products, this shows that conflicts and warnings are going to come more and more to the forefront of regulation and litigation. Better to have an independent advisor who doesn’t have any proprietary products and works only for you. Just saying.

Another keep-an-eye-on-this story is “Michigan City Outsources All Its Schools” on page A3 of the WSJ. I have made the point before that balances are changing in pretty much every political and economic area, but to see a city give up its school system to a for-profit firm is shocking proof of just how much the old certainties are fading. Another story that you can expect to see a lot more about.

One final note: John Keegan, one of the foremost military historians, died on Thursday. I have read many of his books, and he was truly an accomplished writer, analyst, and storyteller. His obituary ran on page A9 of the WSJ. If you have any interest in such matters, I recommend his work highly.

Have a great day!

 

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