Background:
Nordic & German power grids are well connected. Distribution utilities will seek average the cost of power, thereby eliminating the price difference between the 2 power sources.
The trade:
Bet that spread (difference between German and Nordic prices) will converge. The trade:
- long position on Nordic power (cheaper contract)
- short position on German power (more expensive contract)
The price difference is likely to be small, so to be able to make profit, we need to lever up. We estimate he was levered up 30 – 40 times.
The hidden flaw in the trade:
- Poor understanding of mean reversion phenomenon. Longer a market remains stable, higher its likelihood of a catastrophic failure.
- A flaw was the position size relative the market. Aas had cornered nearly 5% of the entire market without sufficient capital to cover his position should something go wrong.
Trigger Event:
2 unrelated & rare events happened simultaneously on 10 Sep 2018 that sank Einar.
- Carbon emission prices (which was best performing commodity in 2018 in Europe) surged up. That pushed up the German electricity prices (because German power producers will need to spend more to buy carbon offsets)
- Wetter weather forecasts sunk the Nordic electricity contract by the most since January 2017. (Wetter weather meant less snow, so less demand for electricity).
Combined & opposite moves caused the spread to widen by 17 times than its long-term average. Aas had a huge bet that spread would narrow.
End game:
Aas was unable to post additional margin. Per established procedures exchange liquidated the positions. Losses being greater than estate of Aas, counterparties ponied up additional $117 Million to cover rest of the losses.
Lessons for the institutions:
- Trader can’t be his own clearer.
- Aas was allowed to be his own clearer, or guarantor of trades. If he’d gone through another clearing member, that company could possibly have stopped the bets earlier by demanding additional collateral.
- Market supply of derivatives should not exceed average liquidity – or there must be a cap on the supply.
- Increase margin requirements.
Lesson checklist:
| Was the trade idea flawed? | No. This is standard arbitrage. Other players had similar positions but didn’t get wiped out because of stop losses. |
| Did market fundamentals change? | No. Everyone got their electricity. |
| Position size | Yes. Too big relative to market size. 5 percent of the Nordic region’s annual demand. |
| Concentration | HIGH. Single pair arbitrage increases risk. |
| Was it a ‘black swan’? | We think Taleb will disagree. This kind of event, while rare, but was possible to imagine. We don’t agree with NASDAQ’s characterisation that this was black swan. |
| Leverage | Yes. Arbitrage trading does involve leveraging, but lacking exact positions, we can only estimate that Aas was levered up 30 – 40x. This is LTCM level leveraging. We will come to LTCM later in the series. |
| Was it a fraud? | No. Just levered spread bet going wrong as they often do. |
Even if no one could predict spread will widen 17x in a day, it is possible to simulate a 5x move, which itself would have sunk Einar. So this wasn’t a black swan event. Just poor understanding of how mean reversion works.
What can we learn from this?
- Pay attention to position size.
- In our stat arb model, no position is more than 2% of capital.
- If arbitrage trading, DO NOT TRADE SINGLE PAIR.
- In our stat arb model, we create & trade 100’s of different arbitrage bets, using our “Statistically Stable Synthetic securities” technology.
- We are going to see SINGLE PAIR disasters in subsequent chapters.
