Did HFTs cause the Flash Crash?

What are HFTs? Source: CFTC and SEC Preliminary Findings Regarding the Events of May 6, 2010 In the U.S., high-frequency trading firms represent 2.0% of the approximately 20,000 firms operating today, but account for approximately three quarters of all equity trading volume.

What is it about HFTs that trouble market participants? HFTs have a time and place advantage over others. – From “’Do it Yourself’ Latency Arbitrage: How HFTs Can Manipulate the NBBO at Whim Courtesy of NYSE Empty Quote Gluts” In summary, at its peak, at 14:45:55 on May 6, the latency between the CQS and OpenBook pricing hit a high of 24 seconds, making a mockery of the NBBO as all those who had premium access to OpenBook were all too aware that 99% of the investing public were seeing pricing data almost half a minute stale, and could trade accordingly on secondary “dark” venues.trade

May 6, 2010 A majority of securities experienced declines that are generally in line with the decline in value of the large indexes. – 86% of securities reached lows for the day that were less than 10% away from the 2:40pm price. – The remaining 14% suffered much greater declines, some trading down to $0.01. Is market structure to blame?

Source: CFTC and SEC Preliminary Findings Regarding the Events of May 6, 2010

Flight to quality?

Source: CFTC and SEC Preliminary Findings Regarding the Events of May 6, 2010

What is a LRP? LRP = Liquidity Replenishment Point Best thought of as speed bumps – Intended to dampen volatility in a given stock by temporarily converting from an automated market to a manual auction market when a price movement of a sufficient size is reached. – When triggered, trading on the NYSE goes slow, giving the market maker time to solicit additional liquidity. LRPs are calculated by the NYSE throughout the day and vary depending on a security’s share price and average daily volume. Source: CFTC and SEC Preliminary Findings Regarding the Events of May 6, 2010

Implications for Reg NMS As part of Reg NMS, we now have a trade through rule – With few exceptions, cannot execute trade at price that is inferior to a price posted by a National Market System participant. EXCEPTION: An exchange may exclude the quotations of another exchange from its determination of whether the other exchange has a better price to which it must route orders if it is experiencing a failure, material delay, or a malfunction in its systems of equipment. – This is called Self Help. – Markets exclude the NYSE when it goes slow.

Source: CFTC and SEC Preliminary Findings Regarding the Events of May 6, 2010

ETFs were hit especially hard Of the U.S. listed securities with declines of more than 60% or more from the 2:40pm trade prices (trades ultimately cancelled by exchanges), approximately 70% were ETFs.

Source: CFTC and SEC Preliminary Findings Regarding the Events of May 6, 2010

Are HFTs to blame? Severe mismatch in liquidity – Made worse by withdrawal of liquidity by HFTs? – ‘Flash crash’ on May 28, 1962? Dow fell 5.7% on that day, second largest point decline then on record. Volume was so heavy the ticker wasn’t able to finish reporting floor trades until 5:59pm (2.5 hours after close).

Flash Crash on May 28, 1962 (1 of 2) Dow fell 5.7% on that day, second largest point decline then on record. – Volume was so heavy the ticker wasn’t able to finish reporting floor trades until 5:59pm (2.5 hours after close). SEC found that “some orders were executed at prices substantially different from those which prevailed when the order was entered.” HFT trading didn’t exist, but specialist trading did – The SEC concluded that “at no time during the day did the specialist intervene in sufficient volume to slow the rapid deterioration of the market in IBM.”

Flash Crash on May 28, 1962 (2 of 2) The SEC later noted that – “the markets’ erratic behavior prompted concern and caused bewilderment at home and abroad. The frenetic activity of the break resulted in large and sudden losses for many and gains for some… this break had a strong and immediate psychological impact on the nation.”

SEC’s list of potential causes… Severe mismatch in liquidity – Made worse by withdrawal of liquidity by HFTs??? – Made worse by the use of market orders – Made worse by use of stop loss orders NYSE’s LRP and the self-help remedy Use of stub quotes – What are these and why are they a problem? No evidence that fat fingers are to blame.

BlackRock ‘Flash Crash’ Perceptions Study Surveyed 380 retail advisors throughout U.S between June 23 rd and June 29 th – Must manage assets in excess of $25 million – Must have used or managed passive ETFs in last 6 months – Must provide investment advice to individuals. 4 out of 5 advisors in sample said overreliance on computer systems and high-frequency trading were cited as primary contributors to the May 6 volatility.

BlackRock ‘Flash Crash’ Perceptions Study Secondary contributing factors – Use of stop loss orders (23%) 28% of advisors had a stop loss order triggered by the crash that traded at a significantly reduced value. – Market makers (21%) – Exchange order routing issues (18%) Contrary to initial media accounts, most advisors surveyed said their accounts were minimally impacted. – Will continue to use stop loss and market orders.

Why so bad for ETFs? Perhaps ETF market makers withdrew liquidity because of an inability to hedge in the volatile market. Selling pressure from institutions seeking to reduce market exposure? Retail investor stop loss orders in ETFs? Loss of NYSE Arca’s liquidity pool! – NYSE Arca is primary home for ETFs – NYSE Arca went slow, other markets could not access NYSE Arca liquidity.

Futures market experience... S&P500 minis – More sell orders than buy orders between 2:30pm and 2:45pm – Bid ask spread starts to widen significantly at 2:45pm – At 2:45:48 CME’s Globex stop logic functionality initiated a pause in trading. Initiated when the last transactions price would have triggered a series of stop loss orders, that if executed, would have pushed prices outside of a predetermined ‘no bust’ range. This functionality is intended to stop/slow large price declines/inclines due to order book illiquidity. – The price of the S&P500 minis rebounded after the 5 second pause. SEC has pushed equity exchanges to adopt circuit breakers on stocks in S&P500 index.

Last words on the Flash Crash (1 of 5) SEC to produce a second report later this month… Mary Shapiro is making noises about more HFT regulation… – Current issue of TradersMagazine.com “Cover Story: Not So Fast! Regulators and Others Question the Need to Trade at Hyperfast Speeds” – The SEC, Schapiro said, would "explore whether bids and orders should be regulated on speed so there is less incentive to engage in this microsecond arms race that might undermine long-term investors and the market's capital-formation function."

Last words on the Flash Crash (2 of 5) SEC has floated three ideas – Set a minimum trading speed – Require a minimum amount of time that a trader must maintain a quote – Require exchanges to batch trades Chris Nagy, managing director, order routing, sales and strategy, at TD Ameritrade, told the SEC in a letter that – "rapid order placement and high cancellation rates have only exacerbated flickering quotations, which undermine retail investor confidence in the execution quality they obtain."

Last words on the Flash Crash (3 of 5) SEC has floated three ideas – Set a minimum trading speed – Require a minimum amount of time that a trader must maintain a quote – Require exchanges to batch trades Chris Nagy, managing director, order routing, sales and strategy, at TD Ameritrade, told the SEC in a letter that – "rapid order placement and high cancellation rates have only exacerbated flickering quotations, which undermine retail investor confidence in the execution quality they obtain."

Last words on the Flash Crash (4 of 5) Thomas Peterffy, chairman and chief executive of Interactive Brokers and a pioneer in the use of technology for trading, said at a recent industry conference: – "There is generally an issue with automation that you have to put many, many safety valves on your technologically sophisticated systems. The oil spill is a woeful example of that. Yes, automated systems can run away. So if you do not have very significant facilities to prevent them from running away, it's a problem.“ Nasdaq OMX told the SEC in a letter: – "Speed is not inherently unfair or harmful; it is the misuse or misapplication of speed that may harm investors or markets." In other words, traders who use their speed advantages to engage in manipulative activities should be censured.

Last words on the Flash Crash (5 of 5) Other proposals by market participants: – High frequency traded is aided by the ability to quickly cancel orders when market transactions change. Some estimate that over 90% of the possible high frequency trades are cancelled. The ability to profit from high frequency trades would be limited by a rule that requires traders to execute trades without cancellation, or more modestly, allow cancellation only after a specified period. – Limitations placed on so-called stub quotes, which are standing orders well off the reasonable price of a stock. – Limitations on the use of market orders and stop-loss selling could also see new limitations. – Clear rules for rescinding trades, which would eliminate confusion when things go awry. While exchanges decided to cancel certain trades occurring during the flash crash, there was little pre-existing authority for how cancellations should be determined and executed.