Reuters - Nasdaq restores Nordic clearing buffer after power trader default

While Aas had bet that Nordic-German spreads would narrow, this backfired on Sept. 10 as heavy rain pushed down prices in the hydroelectric-dependant Nordic region, while a spike in the cost of carbon drove up German prices, Nasdaq said.

In a single day, the difference between Nordic and German power prices for 2019 widened by 5.56 euros, 17 times more than the average daily move and exceeding the maximum level of 4 euros for which Nasdaq Clearing’s risk model had been calibrated.

Since 2011, when the current pricing system was set up, the largest change in Nordic-German spreads on any single day had been 1.6 euros, Nasdaq said, calling the Sept. 10 market move “a true ‘Black Swan’ event.”

A true Black Swan event?

Only if you are (according to the fine terminology of Nassim Taleb, whom I will not introduce here, assuming the reader has not spent the last decade or so hermetically sealed away in an atomic bunker) a sucker. As the Master explains, “a Black Swan for the turkey is not a Black Swan for the butcher.”

Reading and repeatedly re-reading The Black Swan (and Taleb’s other books), even as a dilettante in the fields of probability and risk management I can fully sympathize with his caustic disdain for those econometricians and so-called risk managers who, one full decade after the 2008 financial meltdown (arguably just another in a long list of failures in “managing risk” using the same old, flawed methods) still employ phony Gaussian probability mathematics, only to be wrong with infinite precision.

A double-digit sigma event is a Black Swan only if you attempted to use the methods of Mediocristan (Gaussian distributions, that is) in the land of Extremistan, where they simply do not apply. The sigma loses its meaning – there is no such thing as standard deviation in Extremistan! Alas, both the financial markets and the weather belong to this domain (also called “the fourth quadrant”); it is an irony of fate that both were involved in this very incident.

As history has abundantly demonstrated, bogus application of mainstream statistics grossly underestimates (by several orders of magnitude!) the probability of rare, potentially devastating events in complex systems while providing nothing but a dangerously misleading, comforting illusion of precise knowledge. Every few years or so, we observe a “double-digit sigma” event, one that (according to the prevailing methodology) is not supposed to happen much more frequently than, on average, once per tens of thousands of years.

Worse, engaging in these deeply flawed estimations (purportedly, “scientific measurements”) of risk on behalf of others (posing as an expert, commissioned with the task of protecting others) amounts to intellectual fraud, sustained by a moral hazard arising from lack of “skin in the game.” Further, being apologetic about the inevitable blowups, blaming them on allegedly unmitigable Black Swans amounts to perpetuating this fraud. Taleb is, alas, spot on: the “professionals” do not care about, or maybe do not even understand, what they do not know.

And, oh… the clearinghouse defends itself by stating that the largest change in the last 7 years was only 1.6 euros? Calibrating any risk model to such a comically short time horizon is really asking, no, begging for a blowup. No wonder the event (not the trader default, but the clearinghouse buffer overrun) has attracted some regulatory scrutiny… from the same article:

“Finansinspektionen (the Swedish Financial Supervisory Authority) is following up on whether Nasdaq Clearing has acted in compliance with current regulation and whether the regulation is sufficient,” the Swedish financial markets regulator said in a statement late on Friday.

Amen to that.