RT Leuchtkafer on the Flash Crash Report

The long-awaited CFTC-SEC report on the flash crash has finally been released. I'm still working my way through it, and hope to respond in due course. In the meantime, here is an email (posted with permission) from the very interesting RT Leuchtkafer, whose thoughts on recent changes in market microstructure have been discussed at some length previously on this blog:

It's natural for any critic to focus on what he wants in the report, and I'm no different.

From the report, in the futures market: "HFTs stopped providing liquidity and instead began to take liquidity." (report pp 14-15); "...the combined selling pressure from the Sell Algorithm, HFT's and other traders drove the price of the E-Mini down..." (report p 15)

And in the equities market: "In general, however, it appears that the 17 HFT firms traded with the price trend on May 6 and, on both an absolute and net basis, removed significant buy liquidity from the public quoting markets during the downturn..." (report p 48); "Our investigation to date reveals that the largest and most erratic price moves observed on May 6 were caused by withdrawals of liquidity and the subsequent execution of trades at stub quotes." (p 79)

It's also natural - if ungraceful - for a critic to say "I told you so." OK, I'm no ballerina, and I told you so (April 16, 2010):

"When markets are in equilibrium these new participants increase available liquidity and tighten spreads. When markets face liquidity demands these new participants increase spreads and price volatility and savage investor confidence."

"...[HFT] firms are free to trade as aggressively or passively as they like or to disappear from the market altogether."

"...[HFT firms] remove liquidity by pulling their quotes and fire off marketable orders and become liquidity demanders. With no restraint on their behavior they have a significant effect on prices and volatility....they cartwheel from being liquidity suppliers to liquidity demanders as their models rebalance. This sometimes rapid rebalancing sent volatility to unprecedented highs during the financial crisis and contributed to the chaos of the last two years. By definition this kind of trading causes volatility when markets are under stress."

"Imagine a stock under stress from sellers such was the case in the fall of 2008. There is a sell imbalance unfolding over some period of time. Any HFT market making firm is being hit repeatedly and ends up long the stock and wants to readjust its position. The firm times its entrance into the market as an aggressive seller and then cancels its bid and starts selling its inventory, exacerbating the stock's decline."

"So in exchange for the short-term liquidity HFT firms provide, and provide only when they are in equilibrium (however they define it), the public pays the price of the volatility they create and the illiquidity they cause while they rebalance."

Finally, the report should put paid to the notion that HFT firms are simple liquidity providers and that they don't withdraw in volatile markets, claims that have been floating around for quite a while.

What happens next?

In a follow-up message, Leuchtkafer adds:

I'd like to note there were many other critics who got it right, including (most importantly) Senator Kaufman, Themis Trading, David Weild, and others. They all deserve a shout out.

To this list I would add Paul Kedrosky.

Firms that began to "take liquidity" during the crash would have suffered significant losses were it not for the fact that many of their trades were subsequently broken. I have argued repeatedly that this cancellation of trades was a mistake, not simply on fairness grounds but also from the perspective of market stability:

By canceling trades, the exchanges reversed a redistribution of wealth that would have altered the composition of strategies in the trading population. I'm sure that many retail investors whose stop loss orders were executed at prices far below anticipated levels were relieved. But the preponderance of short sales among trades at the lowest prices and the fact that aberrant price behavior also occurred on the upside suggests to me that the largest beneficiaries of the cancellation were proprietary trading firms making directional bets based on rapid responses to incoming market data. The widespread cancellation of trades following the crash served as an implicit subsidy to such strategies and, from the perspective of market stability, is likely to prove counter-productive.

The report does appear to confirm that some of the major beneficiaries of the decision to cancel trades were algorithmic trading outfits. But I need to read it more closely before offering further comment.