ivantohelpyou

I wonder if anyone was able to arbitrage the Dow Jones Industrial Average against its components yesterday while it was off-the-air on Tuesday.

Dow Jones Indexes today explained that a system problem beginning at 1:50 pm yesterday amid unusually heavy volume caused the 70-minute lag in correctly calculating the value of the Dow Jones Industrial Average (DJIA) and the subsequent downward spike in the reported index value when the problem was corrected at 3:00 pm.

Source: Dow Jones Indexes (pdf)

Let's see. You've got an asset with an "official" price that's higher than what it's worth based on its underlying components. That's a clear arbitrage opportunity. Were people able to execute? Considering that on Tuesday, $4 billion traded hands for the DJIA compared to an average $2.9 billion for Feb. '07, I'd guess the answer was "yes." (Update: InformationArbitrage.com came to a similar conclusion with better charts and a precise trading strategy.)

So what happened?

Michael A. Petronella, president, Dow Jones Indexes, said the problem arose in the system responsible for feeding market data into the calculation system. While the DJIA was still being calculated and disseminated, the calculator was not receiving the underlying component prices of the DJIA on a timely basis. Once the slow data feed problem was recognized, Dow Jones Indexes switched to a redundant market data system. This switch-over caused prices that were received during the latency period to be processed all at once, bringing the index immediately in line with its underlying component stocks.

Source: Dow Jones Indexes (same pdf as above)

This begs the question, if the market data systems can't handle a big day like Tuesday, how will they perform next week when Reg NMS takes effect? Ivy from WS&T wonders:

If there is a capacity problem, this raises red flags since Reg NMS starts on Monday and all the new electronic trading systems go live. No one knows how these systems will interact with each other. The question is: Should we be worried?

Source: WS&T Blog, 2/28/07

In case you're not familiar with Reg NMS, it's a rule that says that securities firms have to find investors the best execution for a trade. Think of it like this: If you're shopping for a can of tomato soup, it may cost $0.98 at Store A and $0.99 down the street at Store B. Used to be, if you went to a soup broker, the soup broker could buy your soup at either store. Under Reg NMS, the soup broker has to call both stores to find out who's got the lowest price and buy your soup for you there. Not so good for the supermarkets or the soup broker, but you get a shiny $0.01 per can. That is, unless, the broker has to tell you, "Oh, sorry, the phone was busy over at Store A, and so I bought your soup at Store B."

Now, consider this: Starting next week, brokers will have to call around to every single market to check on best execution for every single trade. Technically, they're not all going to call at once, since there are market data vendors in the middle piping the data from all of the markets to all of the brokers. But they're going to have to be able to show that they found their customers the best price every time. Think they're happy about that?

Considering the astounding number of moving pieces in the flow of data between buyers and sellers, I'll be very surprised if we don't see some, ahem, glitches popping up with alarming frequency over the next few months. And then we'll hear, "Gee, that Reg NMS was a great idea, but in practice its time has not yet come." Anything to go back to business-as-usual.

Labels: wall street