Did a Big Universa Hedge Fund Bet Help Trigger 'Black Swan' Stock Swoon?

By Scott Patterson And Tom Lauricella

http://online.wsj.com/article/SB10001424052748704879704575236771699461084.html

Shortly after 2:15 p.m. Eastern time on Thursday, hedge fund Universa Investments LP placed a big bet in the Chicago options trading pits that stocks would continue their sharp declines.

On any other day, this $7.5 million trade for 50,000 options contracts might have briefly hurt stock prices, though not caused much of a ripple. But coming on a day when all varieties of financial markets were deeply unsettled, the trade may have played a key role in the stock-market collapse just 20 minutes later.

The trade by Universa, a hedge fund advised by Nassim Taleb, author of "Black Swan: The Impact of the Highly Improbable," led traders on the other side of the transaction—including Barclays Capital, the brokerage arm of British bank Barclays PLC—to do their own selling to offset some of the risk, according to traders in Chicago.

Then, as the market fell, those declines are likely to have forced even more "hedging" sales, creating a tsunami of pressure that spread to nearly all parts of the market.

The tidal wave of selling fed into a market already on edge about the economy in Europe. As the selling spread, a blast of orders appears to have jarred the flow of data going into brokerage firms, such as Barclays Capital, according to people familiar with the matter.

Exchanges, in turn, were clogged by huge volumes of offers to buy and sell stocks, say traders and exchange executives. Even before some individual stocks collapsed to just a penny a share, data from the NYSE Euronext's electronic Arca exchange started to appear questionable, say traders.

In the disarray, some huge superfast-trading hedge funds that now provide much of the liquidity for the stock market pulled to the sidelines. The working theory among traders and others involved in the exchange meltdown is that the "Black Swan"-linked fund may have contributed to a "Black Swan" moment, a rare, unforeseen event that can have devastating consequences.

"Universa alone couldn't have caused the meltdown," said Mark Spitznagel, Universa's founder. "We had reached a critical point in the market, and it was poised to collapse." Barclays Capital declined to comment.

As more details of Thursday's collapse become clear, there is less evidence to suggest a "fat finger" data-entry error caused the collapse. Instead, the picture is one of a rare confluence of events, some linked, some unrelated, that exposed weaknesses in the stock market large and small. Within five minutes, the Dow Jones Industrial Average had lost 700 points as trading seized up in individual stocks such as Procter & Gamble and even exchange-traded mutual funds.

"It did point out that there is a structural flaw," said Gus Sauter, chief investment officer at Vanguard Group. "We have to think through how you preserve the immediacy and yet preserve the liquidity."

The episode highlights a bigger question about the stock market. In recent years, the market has grown exponentially faster and more diverse. Stock trading's main venue is no longer the New York Stock Exchange but rather computer servers run by companies as far afield as Austin, Texas; Kansas City, Mo.; and Red Bank, N.J.

This diversity has made stock-trading cheaper, a plus for both institutional and individual investors. It has also made it more unruly and difficult to ensure an orderly market. Today that responsibility falls largely on a group of high-frequency traders who make up an estimated two-thirds of stock-market volume. These for-profit hedge funds look out for their own investors' interests and not those of investors in the stocks they trade.

Hours before the panic began, there were signs that Thursday wasn't shaping up to be a humdrum day. By 11 a.m., when the Dow was down only about 60 points, selling volume was unusually heavy. One measure of selling—the percentage of stocks falling without first moving upward—was at its highest since the day the market reopened after the Sept. 11 terror attacks, according to Barclays.

By 2 p.m., financial markets of just about every sort were under significant strain. In Europe, the spillover from the Greek debt crisis led to a huge drop in the euro against the dollar and the Japanese yen, as well as a broad bond-market decline. European banks were charging each other higher interest rates to borrow money.

Some 2,800 miles away from Wall Street, in Santa Monica, Calif., Universa placed its trade.

The trade wasn't out of character for Universa, which has about $6 billion under management. Mr. Taleb, who is an adviser to the firm and an investor, gained fame for "The Black Swan," a book that suggested unlikely events in the financial markets are far more likely than most investors believe.

Universa frequently purchases options contracts that will pay off if the market makes a sharp move lower. It posted big gains in the market selloff of late 2008 and launched a fund last year designed to benefit if inflation surges.

Through the trading desks at Barclays, Universa bought 50,000 options contracts, according to people familiar with the matter. The contracts would pay off about $4 billion should the Standard & Poor's 500-stock index fall to 800 in June. It was at 1145 points at the time of the trade.

Back across the country in Chicago, the big trade appeared to have had an immediate ripple in the markets. The traders on the other side of the Universa trade were essentially betting stocks wouldn't post big losses.

But to minimize the risk of losing money, they in turn needed to sell, according to traders.

The more the market fell, the more the traders at places like Barclays had to sell to protect their own positions. This, along with likely dozens of other trades across the market, led to a cascade of selling in the futures markets.

As the stock-trading volume soared, data systems across the stock market began to get clogged. At Barclays Capital, a market data feed that delivers to the firm data on "buy" and "sell" orders went down, although a backup system immediately went online without any impact to the firm.

As the turmoil unfolded, every second saw some 300,000 pieces of stock information—stock prices moves, trades—pour into Barclays's system. A normal peak is some 60,000 ticks a second, says Barclays Capital's head of electronic trading sales, Brian Fagen, who was monitoring the chaos in the market on his screens.

Large hedge funds were juggling huge positions as volume spiked. Two Sigma Investments LLC, a New York hedge-fund manager that engages in complex trading strategies, saw its highest-volume day since launching in 2001, according to a person familiar with the matter.

By 2:37 p.m., the overload seemed to have taken its toll on the NYSE's Arca electronic-trading system. At that point, its rival, the Nasdaq, owned by Nasdaq OMX Group Inc., detected what it felt was questionable information in the data. It sent out a message saying it would no longer route quotes to Arca.

This step, known as declaring "self help," doesn't happen often among the major exchanges. But in the coming minutes, the BATS exchange also stopped automatically routing orders to Arca.

For a crucial set of players—high-frequency-trading hedge funds—all this turmoil was becoming too risky to handle. One fear that would prove all too real was that in the extreme swings, some, but not all, trades would later be canceled, leaving them on the hook for unwanted positions.

Manoj Narang, whose Tradeworx Inc. firm runs a high-frequency trading operation in Red Bank, N.J., began to worry the extreme volatility could lead to painful losses in his fund.

At about 2:40, he and a small team of traders scrambled to close the positions held by the high-speed fund, which trades rapidly between stock indexes and the individual stocks in the index.

Normally, it takes about a fraction of a second to unwind the trades because of the high-powered computers Mr. Narang uses. But as the market plunged, it took about two minutes—an eternity in today's computer-driven market. Tradebot Systems Inc, a large high-frequency firm based in Kansas City, Mo., was also seeing chaotic action in many of the securities it traded and decided to pull back from the market.

With the high-frequency funds either selling or pulling out of the market, Wall Street brokerage firms pulling back and the NYSE temporarily halting trading on some stocks, offers to buy stocks vanished from underneath the market. Normally there can be hundreds of offers to buy the iShares Russell 1000 Growth Index exchange-traded fund, but at 2:46 p.m., there were just four bids north of $14 for a fund that had been trading at $51 minutes earlier, according to data reviewed by The Wall Street Journal.

Around 3 p.m., the selling pressure abated. Just as swiftly as the market fell, it recovered ground. One factor behind the swift recovery, traders say, were funds that use computers and formulas to sniff out bargains in the market. These funds swooped in on hundreds of cheap stocks, helping push the market higher.