Playing The Spanish Crisis, Wall Street Bigs Leave Tracks In Distorted Markets

Never let a perfectly good crisis go to waste. That old adage seems to be the motivating wisdom behind the actions of U.S. investors looking to capitalize on the developing debt crisis in Spain.

Those investors might have been better served by another, even more ancient axiom: Don't tip your hand.

That's because, in a seeming effort to profit from the latest European disaster, large investors are quietly creating massive hedge positions that could pay off if Spain or large Spanish banks like Banco Santander go under. In doing so, these investors are hiding their activities, avoiding regulatory oversight and skewing the playing field to the disadvantage of ordinary retail investors. Moreover, the investment activity is occurring on a large scale, a fact made clear from an examination of the tape, the real-time reports of trades, which show glaring anomalies.

The profit-seeking comes as financial carnage continues to unfold in the Iberian peninsula, with the situation in Spain having become the European crisis du jour.

Bad News

A quick summary: Following a respite in early March, when borrowing costs for the Kingdom of Spain benchmark notes briefly fell under 5 percent, yields on 10-year deuda have skyrocketed, recently exceeding the unsustainable -- and psychologically significant -- 6 percent mark. The rise in borrowing costs has reflected fiscal bumbling on the part of the Spanish government, which appears unable to exercise cost discipline on its highly autonomous provincial governments.

At the same time, the Spanish economy is in deep recession -- youth unemployment in Spain, for example, is at an astonishing 50.5 percent -- and investors lack confidence that the government can avoid going into a financial tailspin. The nation's benchmark stock market index, the IBEX-35, is down a stomach-churning 17.6 percent for the year, and it's just one negative trading session away from lows last seen during the depths of the global financial crisis in March 2009.

And as if further bad news were needed, recent days saw two unsettling developments rock Madrid's markets. First, the government of Argentina announced Monday that it will expropriate oil giant Repsol YPF SA (NYSE: REP) of its holdings in that country, a move that sent one of the largest publicly traded companies in Europe reeling. Then, on Tuesday, a report by the Banco de España noted that the percentage of non-performing loans held by local banks would rise to historic levels, an announcement that prompted a sell-off in the nation's financial sector.

Assuming The Position

As is to be expected, the newest European panic resulted in investors assuming the now more-or-less standard crash position portfolio movements. As sovereign bond prices have plummeted on rising yields, instruments designed to insure against national and corporate defaults -- the now-common credit default swaps, or CDS -- have been in high demand. Trading for CDS related to the sovereign debt, as well as for large bank Banco Bilbao Vizcaya Argentaria SA (NYSE: BBVA), has reached nose-bleed heights. According to the Depositary Trust and Clearing Corporation, gross notional exposure on CDS written to insure the country's debt grew by over $2.56 billion last week, the second-highest spike seen by any issuer in terms of total exposure for the period. Gross national exposure in CDS for BBVA's bonds grew by over $503 billion.

Trading in $122 billion worth of Spanish notes in the secondary government debt market has also been heavy, which has contributed to the daily volatility in yields. Volume in the Bolsa de Madrid, the country's most important stock market, has risen to levels not seen since the financial malaise at the end of last year. And of course, foreign exchange traders have followed events closely in decisions determining how they bet on trillions of euros within the currency exchanges.

Madrid To New York

But there have also been some conspicuous activities in other corners of the market, specifically, in the electronic trading systems of the New York Stock Exchange and the pits of the Chicago Board of Options Exchange.

In New York, trading in American Depositary Receipts of Spanish banks -- stock certificates that reflect underlying shares of a company listed overseas -- has skyrocketed. Traders in Banco Santander SA (NYSE: STD), the largest in Spain, have gone from seeing 3 to 6 million shares change hands on an average day, to now seeing over 10 million shares traded on a regular daily basis. Thursday, volume exceeded 28.42 million shares, the highest figure since Aug. 8, 2011. Average daily trading volume for shares of BBVA, for its part, has more than tripled.

Making the volume spikes more obvious, trading has not been evenly spread out during the day. During the last six New York sessions, Santander shareholders have seen elevated, but still run-of-the-mill activity, in the range of several hundred to a few thousand shares traded at a time, suddenly be interrupted with massive, million-share block trades. Last Thursday provides an excellent example: Even though the day saw tens of thousands of orders filled throughout the day, nearly a full tenth of all trading in Santander stock came from two single trades. At 9:43 am, a single block trade saw 2 million shares exchanged; at 2 pm, 2.5 million shares changed hands in one fell swoop. BBVA shares saw similar trading dynamics in three of the last four sessions.

Dark Pools

Where in the world, some investors might be asking, could those outsize trades be coming from?

An equity market analyst for a New York-based bank, who asked not to be quoted or named due to the sensitive nature of the topic, said those one-trade volume spikes bore the tell-tale signs of over-the-counter block trades being consolidated into the tape.

Large financial institutions, including hedge funds and banks, have trouble clearing big transactions in open exchanges, where the fact that they are trying to buy or sell a large block of securities quickly becomes obvious to observers, causing price movements and thereby frustrating efforts to execute those trades at a stable price. A common way around that problem involves trading through proprietary peer-to-peer exchanges, colloquially known as dark pools, which connect traders without publicly announcing bid and ask details.

The transactions, private when they occur, must eventually be noted in the public record, however. And when they do, single-trade volume spikes like the ones seen in trading for Santander and BBVA can occur.

Puts and Calls

Yet the New York Stock Exchange is not the only place in the U.S. where huge bets on Spain's future are occurring. Even further away from the troubles of Madrid, in a building right across the rumble and grind of the Chicago El train, traders are busy finding yet another way to make money off the crisis. There, at the Chicago Board of Exchange, trading in option contracts for the New York-based shares of the Spanish banks has picked up considerably in recent days.

Bill Luby, an independent investor who writes about options activity for his blog 'VIX and More', notes investors have been loading up on puts of Santander and BBVA through early April, a decidedly bearish bet. Although Luby says options activity has been more balanced in the current week, and is mild in comparison in terms of the activity that was happening last summer, investor interest in betting against Spain remains in the market.

He notes, for instance, how a liquid market has appeared nearly overnight for options in the iShares MSCI Spain Index ETF (NYSEARCA: EWP), an exchange-traded fund that tracks the wider Spanish equity universe. While trading in options for that security was sparse a week ago, Lubby notes it's actually ramped up much more and it's extremely unbalanced on the put side.

Arbitrage Opportunities

An intriguing prospect is that the movements in the Chicago and New York markets could be flip sides of the same coin.

The reason this could be true is the fact that, while trading in the Chicago options market has been unabashedly bearish -- put options are most profitable when the price of the underlying security decreases -- the transactions in the New York Stock Exchange have a bullish tinge to them.

Case in point: Over the past five sessions, as shares of Santander traded in Madrid have dropped 9.43 percent, equivalent shares bought and sold in New York have only gone down some 7.3 percent. For BBVA, the discrepancy is even greater, with the stock down 10.1 percent in Madrid and just 7.7 percent in New York. Such wide differences in price fluctuation, while possible, are not the norm, and they suggest Wall Street is purposefully overbuying the American depositary receipts, perhaps as a strategy to hedge the aggressively negative options bidding.

Those discrepancies make for some interesting arbitrage opportunities, said a New York-based bank stock analyst to whom the situation was described. All of which means that anomalies -- those caused by the complex interweaving of the markets -- seem to have opened a window even retail traders can easily exploit, by shorting the New York-listed Spanish banks.

Of course, anyone wishing to bet on that arbitrage opportunity would be wise to remember yet another old Wall Street aphorism, the one that says there's no such thing as free lunch.

For while it's possible the current market distortions are the unintended consequences of a massive hedge, it's also possible that there's no hedge at all, or that it's an even better mousetrap than anyone could have predicted -- and taking the small money for a ride is all part of the bigger plan.

All that's required to find out is a trading account. That, and the cojones to play with the big boys who, perhaps by mistake, but perhaps by design, just spent hundreds of millions of dollars distorting the market.