2010-10-05 10:33:56
Oct 1st 2010, 18:42 by The Economist online | NEW YORK
Traders baffled at the
MONEYMEN have yet another fat document from regulators to chew over. On Friday
October 1st, America s Securities and Exchange Commission and its Commodity
Futures Trading Commission issued a joint report on the flash crash of May
6th. That afternoon, American share and futures indices went into a seemingly
inexplicable tailspin, falling 10% in a matter of minutes, with some blue-chip
shares briefly trading at a penny, only to recover most of the lost ground
before the end of the trading day. The short-lived plunge raised awkward
questions about whether trading rules had failed to keep up with markets that
now handle orders in milliseconds.
Weighing in at more than 100 pages, the report provides a thorough account of
what happened that day, based on masses of data pulled from trading firms and
exchanges. In the hours before the nosedive, volatility was unusually high and
liquidity thin, thanks to a barrage of unsettling political and economic news.
The main trigger for the sudden decline, the report suggests, was a large sell
order in e-mini futures on the S&P 500 index by an unnamed mutual-fund group
(reportedly Waddell & Reed). Because this automated algorithmic trade was
programmed to take account of trading volume, not price or time, it was
executed unusually rapidly: in 20 minutes, instead of the several hours that
would be typical for such an order.
This is where high-frequency trading firms (HFTs) enter the story. These
outfits zip in and out of shares, often holding them for less than a second.
This fickleness has attracted criticism, with some accusing them of undermining
market stability. HFTs initially helped to absorb the sell pressure, buying
e-mini contracts. Ten minutes later, however, they began forcefully selling to
reduce their long positions. The sell algorithm used by the mutual fund
responded to this increased volume by increasing the rate at which it fed
orders into the market, creating a negative feedback loop.
Two liquidity crises
This created two separate liquidity crises, the report says: one at the broad
index level in the e-mini, the other in individual shares. HFTs began quickly
buying and reselling to each other e-mini contracts. This hot potato trading
generated lots of volume but little net buying. Traditional buyers were unable
or unwilling to step in, and the depth of the buying market for e-minis and S&P
500-tracking exchange-traded funds fell to a mere 1% of its level that morning.
The second liquidity crunch, in individual stocks, began when automated trading
systems used by market-makers and other large liquidity providers paused, as
they were designed to do when prices move beyond certain thresholds. This left
traders to assess the risks of restarting trading. A number of participants
reported that because prices had fallen precipitously across many types of
securities, they feared the occurrence of a cataclysmic event of which they
were not yet aware, and that their strategies were not designed to handle,
says the report.
Some market-makers reacted to this increased risk by widening the spreads
between the levels at which they would buy or sell. Others withdrew completely.
Some resorted to manual trading but could not keep up with the explosion in
volume. It did not help that market-makers in over-the-counter markets (those
that trade off public exchanges) began routing their orders to the exchanges,
where they competed with other orders for immediately available but dwindling
liquidity. HFTs whose rapid-fire trading has been blamed by some for the
collapse in liquidity were net sellers at this time, but so were most other
participants. Some HFTs continued to trade throughout the crash, even as others
reduced or halted trading.
The lessons are complex
The regulators point to a number of lessons that need to be learned. In times
of turmoil, automated orders can trigger extreme price swings, especially if
the algorithm does not take account of prices. And the way in which these
automatic orders interact with high-frequency and other computer trading
strategies can quickly erode liquidity, even amid very high trading volume.
More work also needs to be done to understand how stockmarkets and derivatives
markets interact, especially with respect to index products.
Another lesson is that official trading pauses can be a good way to provide
time for sanity to return to markets, but unco-ordinated breaks can do more
harm than good. On May 6th the New York Stock Exchange stopped trading briefly
while other exchanges and alternative trading venues kept going. This led to a
diversion of order flows that greatly added to the pressure on those markets.
The SEC has since introduced circuit-breakers for individual shares that halt
trading across all markets. These may be modified to allow shares to continue
trading, but only within pre-set bands. The commission has also brought in
uniform policies for cancelling trades struck at clearly irrational prices. And
it is eliminating stub quotes , which thanks to a technical oversight allow
market-makers to buy perfectly good stocks for a penny if there are no other
bids.
Another area that needs to be looked at is market data. Though the report does
not see data delays as a primary cause of the crash, differences in data
conventions among the dozens of markets may have exacerbated it.
Some will no doubt see the report as confirmation that high-frequency trading
is dangerous stuff. In response, the robo-trading crowd will point out that the
algorithm at the centre of the story was executed not by one of them, but by a
bog-standard mutual fund. As the blame game continues, the real question will
be whether the report, and the measures taken to avoid a repeat, help to
restore confidence in today s market structure.