High-frequency trading

This article written by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2022) analyzes high-frequency trading.

Introduction

High-frequency trading is a system that executes buy and sell orders by utilizing an algorithm-based computing platform. The turn of the millennium saw the advent of High frequency trading becoming popular with around 10% of all the trades being executed using algorithms. Initially, the time for execution of trades using HFT was several seconds which eventually shrunk to microseconds and subsequently to nanoseconds by 2012 with the invention of Nano Trading Technology.

The new technology was launched into the market by a firm named Fixnetix and was powered by a microchip executing trades in nanoseconds. By 2012, around 70% of all the US equity traded were executed using HFT platforms. Propagators of this technology credit it with increasing the market liquidity and narrowing the bid-ask spread in financial markets, thereby making markets more efficient.

The Flash Crash (6^th May 2010)

A flash crash refers to a rapid decline in the prices of securities or commodities triggered due to several reasons, automated trading being a primary one.

The computer-based trading technology suffered a lot of criticism during the year 2010 when an algorithm-driven sale of $4.1 billion worth of E-mini futures, resulting from political tensions arising in Greece, brought short term turbulence in the US markets. The futures sale triggered a rapid 1000 point or 9.2% drop in the Dow Jones Industrial Average which was unprecedented in history. The initial sell order resulted in a wave of other sell-offs triggered by the designed algorithms, causing a big downfall in the market. The orders resulted in a whip off of around $1 trillion in the total market value. However, the dip didn’t last very long and the markets recovered by the end of the day, closing at 3% lower than the previous closing price. But the sudden crash made SEC aware of the dangers the algorithm-based trading carry and made them skeptical about its usage.

The Flash crash of 2010 has resulted in HFTs being subject of regulatory discussions, with critics citing it as a major reason for increased volatility and uncertainty in the markets. Also, HFT has been regarded as a bane for the modern financial markets as it gives an unfair advantage to large scale firms, not providing a fair playing field to small scale investors.

Relevance to the course

 With most of the big firms employing computer-based technology to execute trades, the concept of high frequency trading dominates the financial market in the present days. The Simtrade platform encompasses courses on exchanging orders and the different types of orders a trader can enter to execute his position. Coupled with algorithm-based platforms, basic knowledge of orders can provide a trader with an excellent opportunity to execute 1000s trades simultaneously across different markets. With more and more regulations coming in, the evolution and increased usage of HFT’s can play a key role in increasing the overall value of a trader’s portfolio.

An interesting video to understand the 2010 crash:

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About the author

Article written in October 2020 by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2022).

The bankruptcy of Lehman Brothers (2008)

This article written by Akshit GUPTA (ESSEC Business School, Master in Management, 2022) analyzes the bankruptcy of Lehman Brothers (2008).

Introduction

A financial crisis refers to a situation in which financial assets in an economy experience a steep decline in their value triggered mainly by investor panic and irrational behavior resulting in bank runs where investors are keen to unwind their positions. It generally begins with a stock market crash, currency crisis, or bursting of a financial bubble. The global economy has faced many such financial crises in the recorded past starting from the infamous Tulip Mania in 1637 to the most recent financial crisis of 2008.

The crisis of 2008 was not unusual, but it led to the extinction of some of the giants in the investment banking industry, including the 4^th largest investment bank of the USA, Lehman Brothers.

The Bankruptcy

Lehman Brothers, founded in 1847, was a global financial services firm dealing in a wide variety of financial businesses ranging from investment banking, investment management to equity and commodity trading. The firm was a victim of the great financial crisis of 2008, one of the most devastating crises, that swept away trillions of dollars from the US equity markets.

In the early 2000s, Mortgage-Backed Securities (MBS), a type of asset-based security, became a trending investment class with collateral debt obligations (CDO) gaining traction. In a CDO, different tranches of home loans were pooled in depending on their credit rating. As the instrument started gaining attraction of big investment banks, demand for mortgages started increasing leading to the issue of subprime category mortgages (mortgages with high default risk), which played a key role behind the crash. Easy lending standards and the issue of subprime home loans lured customers from all the segments of the economy, thereby driving up the housing prices, which peaked in 2006. With the boom in the market, Lehman acquired some big mortgage lenders in the market to issue loans at an increased pace. By 2007, the bank was generating huge profits to the tune of around $4.2 billion in net income and $19 billion in revenues.

Soon, the subprime mortgage borrowers, lacking payment capacity, started defaulting on their loans and the CDOs, which were based on these mortgages, started seeming overvalued. As loan defaults kept on rising, the instruments started losing value with banks facing difficulty in unloading their heavy positions in these assets. The bubble busted and the entire US economy came at the brink of collapsing. In the middle of all this, Lehman Brothers, who held a huge position in these assets faced a stiff liquidity crunch. The business model followed by the company involved high leverages and investments in very risky asset classes like subprime mortgages and real estate. Failing to undertake a firm restructuring or receive a government bailout, the bank filed for Chapter 11 bankruptcy protection on 15 September 2008 with around $619 billion in debts and $639 billion in assets, making it the largest bankruptcy in US history.

Soon after the declaration of bankruptcy, Barclays purchased the North American investment banking and capital market business of Lehman Brothers at a mere valuation of $250 million, giving them entry to the Wall Street.

The role of FED

The Central Bank of the USA raised interest rates in 2006, making it difficult for the homeowners to make their monthly payments. The increase resulted in a series of loan defaults, driving the market towards a crisis. Although the fall of Lehman Brothers was a by-product of their poor risk management, still the role of the FED, chaired by Ben Bernanke, in not bailing out such a giant financial institution is still questioned by many till date. Having provided bailouts to other banks such as AIG and Bear Stearns, the FED’s actions were called as highly discriminatory. Concrete efforts were made to sell the bank to other players like Korea Development Bank, Bank of America and Barclays, but nothing turned successful. The then-Secretary of the Treasury, Henry Paulson, a former CEO of Goldman Sachs, said it would be illegal to provide a bailout to the bank, stating insufficient collateral held by the bank as the primary reason for not extending the funds.

 The role of Rating Agencies

Credit rating agencies play a pivotal role in shaping the financial markets around the globe. They impart credit risk ratings to various institutions and asset classes to reduce the information gap, based on which investment types are deciphered. These ratings are provided on the basis of various grounds ranging from background checks, risk reports, and performance evaluations. During the crisis of 2008, the role played by credit rating agencies is still criticized by many. Days before the fall of Lehman Brothers, big rating agencies like Standard & Poor’s and Moody’s maintained an A rating for most of the assets of the firm which later turned out to be toxic. The ratings made the assets into investment-grade opportunities and provided a false image of its true value. The CRAs were believed to have given biased ratings and had a serious conflict of interest.

After-effects of this event

The bankruptcy of Lehman Brothers triggered the financial crisis of 2008 as investors started losing trust in the financial institutions and started cashing in on their investments to preserve liquidity. The crisis brought a serious recession in the global markets and the unemployment rates reached 10.2% in the USA by the end of 2009. The Federal Reserve took immediate measures to combat the situation and flooded the market with liquidity, reduced interest rates, and bailout funds, to protect large financial institutions. The financial measures were followed by the enactment of the Dodd-Frank Act in 2010, placing heavy regulations on the risk exposure of large financial institutions, in anticipation of reducing the likelihood of such events in the future. The crash took away the life savings for many retail and small investors, thereby decreasing the cumulative consumer wealth. To safeguard the interest of investors and oversee the financial products offered to consumers, a new Consumer Financial Protection Bureau was also set up. Over the period, the crash has changed the dynamics of how people used to save or borrow globally.

Securitization Process of Credit Structured Products

Key Financial Terminologies

• Mortgage-Backed Securities (MBS)- These are asset-based securities that are secured by a collection of mortgages. The mortgages held by commercial banks are sold to investors, which are mostly institutions, who combine them into MBS which can be further sold to individual investors. The MBS can be mainly divided into two types namely pass-through certificates and collateral debt obligations.
• Collateral Debt Obligations (CDOs)- Mortgages belonging to different risk categories, also called tranches, are combined into bundles based on their credit ratings, time to maturity, and payment terms. These securities have quite complex structures, making it difficult to regulate them.

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About the author

Article written in October 2020 by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).

The Tulip Mania of 1636

This article written by Akshit Gupta (ESSEC Business School, Grande Ecole Program – Master in Management, 2022) analyzes the Tulip Mania.

Introduction

The Tulip Mania or commonly referred to as The Tulip Craze is an event that took place in Northern Netherlands in the first half of the 17^th century wherein the prices of bulb of tulips skyrocketed, giving rise to a speculative bubble, and crashed all of a sudden affecting the entire Dutch economy. The first evidence on the occurrence of this mania was presented by Charles Mackay in his book Extraordinary Popular Delusions And The Madness of Crowds released in 1841. Tulips were introduced in the Netherlands during the 1590s and were primarily imported from Turkey. Initially, the buds were so rare that it became an item of luxury and only affluent people were able to procure it. It soon became a status symbol among the rich people with new demand arising from the middle-class merchants to match the upper-class status. With professional cultivators coming in the early 17^th century, new techniques were evolved to grow tulips in the home soil, thereby establishing a booming business sector.

The Tulip Mania

Before 1635, the exchange of tulip bulbs was restricted between the professional growers and affluent richer class but sooner the ordinary people started demanding these luxuries. The local cultivation of the flower leads to the evolution of a new variety of buds named ‘broken bulb’ which is believed to be the primary catalyst resulting in exorbitantly high prices of tulips and the creation of the speculative bubble. Middle-class people started spending their annual salaries to buy these rare bulbs in expectation of selling it for a higher profit.

The rare tulip bulbs are believed to be priced at six times the annual salary of an average person at the peak of the crisis. Assets were kept as mortgages to buy rights for these rare bulbs and later sell it at a higher price. However, the craze wasn’t long sustained as within a year people started doubting the extremely high prices, and within a matter of a few days, the entire structure crashed leading to an economic downturn. Many ordinary people have been believed to go bankrupt, deprived of their entire fortunes. The Tulip Crisis is regarded as the first such financial bubble which has happened to exist in the recorded history.

Relevance to the SimTrade course

The lesson learnt from such a crisis very well blends with the courses taught in the SimTrade course. A  speculative bubble comes into existence when the market behavior drives up the asset prices exorbitantly and the fundamentals of an asset nowhere match such an upsurge. The crisis teaches us the pivotal role demand and supply play in bringing volatility to the markets. In the tulip craze, the intrinsic value of the commodity is no way near the market price for such trades. To invest wisely, an investor has to take into consideration the intrinsic or fair value of an asset in order to stay away from such bubbles that come into existence time and again. The concepts of value investing as proposed by Benjamin Graham should always be practiced to select a winning trade.

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Useful resources

Extreme Events in Finance

About the author

Article written by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2022).

The Great Stock Market Crash of October 1987

This article written by Akshit Gupta (ESSEC Business School, Master in Management, 2022) analyzes the Great Stock Market Crash of October 1987.

Introduction

A stock market crash refers to an abrupt drop in the prices of a major stock index, triggered by a drop in underlying stock prices, resulting from speculations, investor panic, or an economic crisis. 6 major stock market crashes have been recorded in the United States till date where the indexes have tumbled more than 10% in a single market day. Known as the Black Monday, the stock market crash of 19^th October 1987 has been regarded as the most significant or largest single-day fall in the history of US markets. The day was dominated by aggressive selling and situation of great investor panic across the country.

The stock market collapse of October 1987

Late 1985 onward, the US markets started to gain momentum after prolonged years of slow growth and economic recession. The financial systems also saw a heightened level of M&A activity with leverage buyouts becoming the new norm. The use of leverage started to be extensive in all areas of the system. In August 1987 the markets peaked with DJIA standing at 2,722 points, up 44% from the same time during the last year. Some investors became concerned about an existing stock bubble or a near term market correction. A new investment strategy named portfolio insurance started gaining traction from many big institutional investors, as a way to hedge their bets in case the market tumbles.

This strategy used algorithm-based trading and relied on the use of options and futures to safeguard an investor’s money. Also, the presence of risk arbitrage or merger arbitrage, who were making profits from announced M&A deals, was on a rise.

On 13^th October 1987, an anti-takeover bill was introduced in the US by the House Ways and Means Committee, placing restrictions on takeovers and corporate restructuring resulting in lower investor sentiments and a break on the then-active M&A environment as a result of higher interest rates due to a larger trade deficit. The leveraged risk arbitrage traders started unwinding their positions owing to fears of failing M&A deals. The selling continued till 16^th October 1987, when investors started selling their positions to avoid further margin calls. Due to the newly introduced globalization and intertwining of global exchanges, when markets opened on Monday, sharp selling in the US market resulted in a chain effect affecting all the major stock exchanges across the world.

On the day of 19^th October 1987, also known as ‘Black Monday’, the indexes across all the major stock markets across the world took a big hit and the U.S. Dow Jones Industrial Average lost 23% of its value in a single market day. The crash was exuberated by the presence of algorithm-based trading, as the sell orders spiked when a target price was breached. As a result, mutual funds started unwinding their positions triggered by increased mutual fund redemptions. The fall in the spot market was followed by a fall of the futures and options markets as a result of excessive short selling by portfolio insurances to hedge the decline in stocks. The intensity of the total trading volume can be gauged by the fact that computerized systems like SuperDot at NYSE failed and were shut down for a prolonged period of time.

The event was a result of high selling pressure continuing for the past several days before the crash day. Although the exact reason for such a crash is difficult to comprehend, it is believed that high-interest rates, the introduction of an anti-takeover bill, algorithm-based trading, and intervention of portfolio insurances are the reasons that led to this forced selling and the biggest crash recorded in the history. The crash brought fears of prolonged economic instability and recession across the world.

After effects of the stock market crash

The significant losses incurred on Black Monday weren’t followed by times of economic recessions. The markets regained their momentum by 1989 and recovered most of the lost value. After the crash of 1987, strict measures were adopted by all the major stock exchanges around the world, to prevent such events from happening again. A new mechanism known as ‘circuit breakers’ was introduced to curb any such sudden declines in the market. Under this new system, exchanges halt the trading for a short duration of time, if the markets experience any such large decline in the prices. To bring liquidity to the market, Open Market Operations were carried out by the Fed to increase the supply of money. Also, other preventive measures were adopted to rectify the market irregularities that led to investor confusion and delay in information processing.

Potential impact of market crashes

The occurrence of such a catastrophic event decreases investor confidence and the after-affects stay for the following many years. As per the wealth effect, consumer spending decreases following such crashes as an individual becomes more hesitant to spend money. The crash of 1987 had a negative impact on the wealth of many individuals, eroding lifetime savings many investors.

Also, as pension funds invest significantly in the stock market, a prolonged decline in the stock prices reduces the value of these funds, thereby effecting the payout capabilities. If the fall in the prices is long-term, the pension income for many households decreases, thus reducing the overall spending power in the economy.

Article written by Akshit GUPTA (ESSEC Business School, Master in Management, 2022).

Analysis of The Wolf of Wall Street movie

This article written by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022) analyzes The Wolf of Wall Street movie.

The Wolf of the Wall Street (2013) is an American drama movie based on true events showcasing the life of an infamous stockbroker and trader, Jordan Belfort. The movie shows how Stratton Oakmont, the firm founded by Jordan and his friends, was involved in a series of large scale corruption and scams that managed to dupe people into investing their hard-earned money in penny stocks. On the marketing side, the use of high-pressure telephonic tactics and scripted talks has been shown as an effective measure to lure people into these scams.

Key characters in the Movie

• Jordan Belfort: Founder of Stratton Oakmont
• Donnie Azoff: Co-founder of Stratton Oakmont
• Naomi Lapaglia: Wife of Jordan Belfort
• Aunt Emma: Aunt of Naomi residing in England
• Patrick Denham: FBI agent
• Jean-Jacques Saurel: Swiss Banker

Summary of the movie

The movie starts by introducing Jordan Belfort, a 22-year-old stockbroker, who has joined an investment bank named L.F. Rothschild, based out in Wall Street. He learns the art of generating high commissions, through his aggressive stock pitching, very quickly while working under Mark Hanna, a senior stockbroker at the firm. The unfortunate Black Monday of October 19, 1987 occurs, resulting in termination of Jordan’s job at the bank.

To move forward with his career, Jordan joins a Boiler Room stock brokerage firm in the Long Island, named Investors Center. The firm deals in unlisted penny stocks and pink sheets while engaging in illicit businesses with high commissions up to 50% of the traded value. In his initial task, Jordan is made to pitch the stock of a company named Aerotyne, a pink sheet stock of a company based out in a small garage. Jordan is lured by the amount of potential this business carries. Using his impressive sale tactics, he makes a good fortune while working at the firm.

While eating at a restaurant, Jordan meets Donnie Azoff, his neighbor, and both of them become friends instantly. They decide to open up a brokerage firm, named Stratton Oakmont, and recruit Jordan’s friends as the senior brokers at the company. Their business model relies on luring the top 1% population of America and gaining their confidence by pitching blue-chip stocks initially. As the investors becomes loyal to the firm, Jordan and his friends would sell them unlisted penny stocks, on which the company would earn high commissions. The simple pump and dump deal made Jordan a millionaire within a short span of time. As the company grew, the founders started living a lavish life spending on drugs and other illegal needs and also recruited more employees to expand their operations. The company became a big name on the Wall Street with the Forbes magazine publishing an article about them. The excessive limelight brought the firm under the radar of the FBI and SEC starting to investigate the operations of the firm. Jordan brings in his father to oversee the bank accounts for his firm. To remain safe from any issues, Jordan also hires a legal advisor to keep a check on the legal formalities.

After finding out about his extramarital affair with Naomi Lapaglia, Jordan’s wife divorces him and soon he marries Naomi in a fancy wedding. To gain more popularity, the company decides to launch the IPO of then-famous brand Steve Madden. Jordan and Donnie together hold around 50% of the listed stocks of Steve Maddens and when the stock becomes a success they make profits of more than $20 million within a day. The IPO makes the FBI more suspicious about the firm and they start their investigation on the same.

To keep his illicit money safe from all the authorities, Jordan decides to store it in offshore accounts in Switzerland and takes a trip for the same. Together with his friends, Jordan meets a group of bankers led by Jean-Jacques Saurel and decides to open up an account in the name of Naomi’s aunt, Emma, who is a European passport holder. The smuggling of cash takes place over the next few weeks and is deposited in the offshore accounts.

Jordan’s private investigator informs him about his phone being tapped by FBI agents to gather proof against him. Cautious about his moves, Jordan initially decides to step down from his company but later changes his mind, when requested by his colleagues.

Jordan takes a trip to Italy with his wife and Donnie’s family and operates his business from there. But soon, the news of Aunt Emma’s demise arrives and Jordan decides to go to Switzerland via Monaco, on a yacht to safeguard his money. The yacht is knocked over by a sea storm and the group barely escapes the incident.

Taking it as a signal of God, Jordan decides to sober up his life and changes his lifestyle. Two years after the incident, Jean Jacques Saurel is arrested in Switzerland in some cases unrelated to Jordan but he confesses about Jordan’s illicit business and accounts. As fate had its own plans, Jordan is arrested with overwhelming proofs. Jordan’s lawyer tries to cut a deal with the FBI and in return, Jordan is asked to turn upon his other friends involved in the scam. He agrees and his prison sentence is reduced to 36 months, completing which he turns into a public speaker and talks about his effective sales tactics.

Relevance to the SimTrade course

The lessons taught in the movie perfectly blends with the concepts that are taught on the SimTrade course. The movie depicts the effective use of concepts such as “Demand & Supply” and ‘Market Manipulation’ to generate high profits. The technique used by Jordan involves creating a need for a product in the market and building trust with his clients to sell that product. The high-pressure sale tactics were at the core of this fraud which involved duping thousands of investors and creating an urgent demand for products that had the so-called potential to earn fortunes.

The financial frauds shown in the movie include “pump and dump” schemes which were very prevalent in the financial markets until a few years back. The scheme involves inflating the prices of penny stocks or pink sheet stocks to high levels and then selling them at those prices to crash the market and make huge profits. The brokers were involved in creating artificial demand for the stocks, that were otherwise worthless, and hampering the free and fair operations of the market, thereby manipulating it. The alertness and effectiveness of market regulators and agencies are what helped stop such schemes to operate openly in the markets and safeguard investor’s interest. Instead of working towards generating high commissions and fulfilling their ambitions, stockbrokers should engage themselves in building trust with their clients by keeping their interests in mind.

Most famous quotes from the movie

Please find below some quotes from the movie that may help you to progress in your professional career:

“The only thing standing between you and your goal is the bullshit story you keep telling yourself as to why you can’t achieve it.” – Jordan Belfort

“97% of the people who quit too soon are employed by the 3% who didn’t.” – Jordan Belfort

Trailer of the movie

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About the author

Article written by Akshit GUPTA (ESSEC Business School, Grande Ecole Program – Master in Management, 2019-2022).