RT Leuchtkafer follows up on his earlier remarks with a comment in the Financial Times:
After a detailed four-month review of the flash crash, looking at market data streams tick-by-tick and down to the millisecond, the SEC concluded that a single order in the e-mini S&P 500 futures market ignited an inferno of panic selling. It was over in about seven minutes, and $1,000bn was up in smoke.
Within hours of the SEC’s report, the CME Group, owner of the Chicago Mercantile Exchange, issued a statement to point out that the suspect e-mini order was entirely legitimate, that it came from an institutional asset manager (that is, the public), and was little more than 1 per cent of the e-mini’s daily volume and less than 9 per cent of e-mini volume during and immediately after the crash.
How did this small bit of total volume cause such a conflagration?
You do it with computers. Specifically, you do it with unregulated computers. You pay rent so your machines sit inside the exchanges, minimising travel time for your electrons. You pay licence fees so your computers eat their fill of super-fast proprietary data feeds, data containing a shocking amount of information on everyone’s orders, not just on your own.
And when your computers spot trouble, such as a larger than expected sell-off, they dump inventory and they shut down – because they can.
No one knows what a “larger than expected sell-off” might be, but on May 6 a single hedge that added just an extra 9 per cent of selling pressure was enough to cause chaos.
When that happened, the SEC’s report says, high-frequency traders “stopped providing liquidity and began to take liquidity”, starting a frenzied race for anyone willing to buy. The report likened the panic to a downward-spiralling game of “hot potato” where, as HFT firms bought beyond their risk limits, they pulled their own bids and frantically sold to anyone they could, which were often just other HFT firms, who themselves quickly reached their risk limits and tried to sell to anyone they could, and so on – into the abyss. Fratricide ruled the day. Firms then fled the market altogether, accelerating the sell-off.
Punch drunk, markets rebounded when other market participants realised what had just happened and jumped into the market to buy.
Fair enough, some might say. Markets do panic, and sometimes for no reason. But the larger HFT firms register as formal marketmakers, receiving a variety of regulatory advantages, including greater leverage. All of this extends their enormous reach and power. In the past, they fulfilled certain obligations and observed certain restraints as a quid pro quo for those advantages, a quid pro quo intended to keep them in the market when markets were under stress and to prevent them from adding to that stress. Over the past few years, however, decades-long obligations and restraints all but disappeared, while many advantages stayed.
Computing power also opened marketmaking to a field of unregistered, or informal, high-frequency marketmakers, what investor and commentator Paul Kedrosky termed the “shadow liquidity system”. Exchanges will pay you to do it, too, just as they pay formal marketmakers, and require little in return.
The result is a loose confederation of unregulated, or lightly regulated, high-frequency marketmakers. They feed on what many consider confidential order information, play hot potato in volatile markets, and then instantly change the game to hide-and-seek if even a single hedge hits an unseen and unknowable tipping point.
The only quibble I have with this analysis is that too many different classes of algorithmic trading strategies are being bundled together under the HFT banner. In particular I would like to see a distinction made between directional strategies that are based on predicted short term price movements, and arbitrage based strategies that exploit price differentials across assets and markets. Both of these can be implemented with algorithms, rely on rapid responses to incoming market data, and involve very short holding periods. But they have completely different implications for asset price volatility. It is the mix of strategies rather than the method of their implementation that is the key determinant of market stability.
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Update: Leuchtkafer writes in to say:
I should have been clear in the piece I was talking specifically about market making strategies.
I appreciate the clarification, and agree with his characterization of the new market makers.