The Prevailing Wisdom of the Perfect Storm

It wasn’t the best of times and… well the worst was avoided. We live in an age of incredible knowledge, whether in computer technology, mathematical sciences or financial engineering, it’s beyond the wild imagination of our ancestors. Yet at times that knowledge does not translate well into the wisdom necessary to foresee that the creation of complex inter-dependent systems has loopholes that could in fact result in a cascading failure event.  Then of course we assert that knowledge once again in an attempt to apply reactionary  remedies when a crash happens. Wisdom on-hold.

The SEC’s flash crash report and the subsequent preponderance of commentary describe a confluence of events, a perfect storm so to speak of the calamity on May 6th. It details the tipping point as a single large order of 75,000 E-mini contracts from a mutual-fund, Waddell & Reed on the futures market. According to the CME’s response it was a mere 9% volume during the time period in which the orders were executed. Yet the ensuing hot potato or ‘circular trading‘ effect spiraled volumes wildly,  which in turn triggered even greater trade activity. It did cause the CME’s Stop Logic protection system to kick-in and pause trading for 5 seconds, but the futures market did remain somewhat stable. To their own admission it is the highly correlated and inter-dependency with specific ETF and the cash equities markets where lightning struck as the sell pressure found few buyers driving down prices. Market Orders began hitting on stub quotes as liquidity dried up.  Eventually six of the largest HTF firms withdrew from the market when their risk systems detected potentially excessive exposure and/or ‘bad data’. Within a few minutes, prices rebounded and a sense of normalcy returned to the markets. The after shock of this brief flash of instability, and the actions of HFT firms has been the scrutiny of countless pundits and the media ever since.

The typical consumer media outlet has a predetermined value judgment on HFT – primarily because it’s machines making decisions. This was never more apparent than on the 60 minutes Speed Trader segment. They demonized machines for not having any personal knowledge of the companies they traded, such as “who is the CEO?”.  I fail
to see the relevance of such a question or concern.  What is the goal of the pension fund manager or the private investor managing their 401k?  I think the answer is simple and obvious; to turn a profit from buying & selling securities. The use of computers strives for the same goal – just faster. The media is passing a moral judgment on a system that has driven down overall costs, created a greater level of fairness and provided jobs for thousands in the value chain of technology.

The correlation between the derivatives and equities markets is at the heart of cross-asset trading and hedging and is the focus of regulatory bodies as they take steps toward rules to prevent another such crisis. Measures to tighten the market and provide a sense of stability for the general investor (and their 401k), asset managers and long-only funds would be the goal. Of course they have to do this without creating an environment where the alpha dries up and HFT’s simply pack up and leave. HFT firms provide the lion’s share of the liquidity in the market.  A few specific noteworthy measures being considered:

Minimum quote duration. On the surface this sounds like a reasonable regulation since it would mean that the liquidity that is seen in the book at any point in time is actually in-fact real and not the result of quote stuffing by rouge firms.  However, the counter-point is any algo with limit orders resting in the book – monitoring price movements cannot pull the order if the price moves against them, doing so could violate the minimum duration rule. I’ve known FX single-bank providers, with a streaming Quote model to have their own (internal) version of this duration rule, where a quote is valid for say 500 milliseconds. In that specific case, the bank was under no obligation to honor a trade that was ‘close’ to timing out if the price was already or trending against them.  With a government-mandated rule, for trader and brokers such a luxury won’t be available.
Taxing Order cancellation. This is clearly a draconian measure and should be completely avoided. It will hurt not only HFT’s, but any/all players in the market. It will likely drive more flow to dark pools (something regulators already are concerned about).
Market Maker obligations for HFT. This rule is nonsensical, it would potentially mean, in turbulent times that funds would be obliged to fill orders to a point that their own exposure and possible leveraged risk is at the extreme. No firm will do that, they would rather risk a penalty.  Natan Tiefenbrun in his HFT Bashing article refers to this rule as “not grounded in reality“.

As regulatory bodies set about their research efforts to ascertain a new set of regulations I for one hope that wisdom prevails.

Once again thanks for reading,

For an occasional opinion or commentary on technology in Capital Markets you can follow me on  twitter, here.

About Louis Lovas

Director of Solutions, OneMarketData, with over 20 years of experience in developing cutting edge solutions and a leading voice in technology and trends in the Capital Markets industry.
This entry was posted in Algorithmic Trading, Analytics, Complex Event Processing, Equities, Foreign Exchange, Futures and Options, Tick database. Bookmark the permalink.

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