Friday, October 01, 2010

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. 


  1. I still strongly suspect the May 6 flash crash was caused INTENTIONALLY as I also believe the "mini flash crash" of April 28, six trading days earlier was INTENTIONALLY caused. If you look at the two events the similarities are striking. And I don't think NYNEX or FINRA or any of the other puppets of the securities dealers/ investment banks has an sincere interest in sniffing out the perpetrators or exposing them if they knew. I think if you are a long -term investor the point is relatively moot. If you are a short-term trader---watch your back.

  2. Rajiv -
    be sure to check out page 65 in the report (page 68 in the pdf) for an explanation of the short sales. I know you and I had previously discussed that - the SEC said that they screwed up their initial report's conclusions!

    "As noted previously, many internalizers of retail order flow stopped executing as principal for their customers that afternoon, and instead sent orders to the exchanges, putting further pressure on the liquidity that remained in those venues. Many trades that originated from retail customers as stop-loss orders or market orders were converted to limit orders by internalizers prior to routing to the exchanges for execution. If that limit order could not be filled because the market continued to fall, then the internalizer set a new lower limit price and resubmitted the order, following the price down and eventually reaching unrealistically-low bids. Since internalizers were trading as riskless principal, many of these orders were marked as short even though the ultimate retail seller was not necessarily short.51 This partly helps explain the data in Table 7 of the Preliminary Report in which we had found that 70-90% of all trades executed at less than five cents were marked short.

  3. KD, thanks, this is interesting. Do you see anything in the report that explains the Sotheby trades at 100K per share?

    I still haven't posted anything on your idea that the entire market should be one big dark pool - which I think has a lot of merit. If you've written any more on this let me know.

  4. Rajiv - I thought I'd left another comment here, but I don't see it - regarding the chart on page 55 (58 of the pdf): HFT % sell dollar volume - pretty consistent throughout the day.

    RT's "beauty is in the eye of the beholder" thesis is so true - I thought the report was a vindication of HFT! As if it was the SEC's way of trying to calm the public - telling them "the computers are not stealing your money."

    of course, the mainstream media runs with different angles... even HFT critics are unhappy with the report though!

    i haven't written any more about the single dark pool concept - i don't know what more to write! that's pretty much it...

  5. KD, I'm not sure why your comment didn't post - I didn't get notification and certainly didn't delete it.

    I think it makes no sense to be for or against HFT... it's the underlying trading strategies that matter and there's a lot of heterogeneity across firms in this regard. In general, momentum based strategies will be destabilizing if sufficiently widespread, while arbitrage based strategies should be stabilizing or neutral. What I can't tell from the report is the mix of strategies that were in use during the crash, but perhaps this is not something that can be deduced from the data.

  6. It makes perfect sense (logic) to be against HFT when one or a very small minority of market participants (players) can manipulate the market price within their own buy and sell time frame---and of course this is exactly what is happening. A professor should get that.

  7. Ted, it's the manipulation that's the problem, not the frequency of trading.

    For example, authorized participants who use the creation and redemption mechanism to keep shares of exchange traded funds in line with net asset values trade with very high frequency but are not taking directional positions or manipulating prices. The focus should be on the strategy and not the machinery, that's all I'm saying.

  8. Professor Sethi, with all due respect (and I do respect you)

    I think it's obvious to everyone ETF funds are not the crux of this problem (ETFs are the cause of many probs, too high stock market correlation (beta), the encouragement of retail investor ignorance, and stealing people's retirement money with fees being three of those probs). But at the same time to say "it makes no sense to be for or against HFT" in my opinion is a very poorly choiced statement.

    If automatic weapons were readily available for convicted felons to pick up from a vending machine located just outside the exit of your local federal penitentiary would you say "it makes no sense to be for or against guns"?? After all "it's the gun-holder's mindset, not the automatic weapon". Nobody is blaming ETFs, it's the hedge funds and large investment banks trading desks that are pissing on the retail investor. But I can already tell you what guys like KD will probably say when you even hint at taking away HFT from the hedge fund and big investment bank trading desks.

    Also, you are not addressing the fact that HFT allows people (in the short-term) to manipulate the "market" price based on bids that they are fully aware will never be executed, and that fact is inherent in the practice of HFT trading.

    In other words---the HFT is like a gun that randomly shoots retail investors. And yet you seem to be saying if the shooter wasn't trying to kill the random victim, it had nothing to do with the gun.

  9. Ted, there are huge problems with current market microstructure, some of which are related to HFT, but I really don't think the gun analogy is terribly helpful or clarifying.

    ETFs and ETNs were central to the flash crash:

    "Nasdaq has released a list of 281 securities that saw unusual activity during yesterday’s “flash crash” on the market... In all, 193 of the 281 securities (68.7 percent) on the NASDAQ list were exchange-traded funds or exchange-traded notes... The New York Stock Exchange has published a similar list, detailing 173 different securities whose trades will be cancelled. In all, 111 of those securities (64.2 percent) were ETFs or ETNs"

    See my earlier post for more on this. It's really important to separate the arbitrage from the momentum strategies if we want to get a handle on what's going on here and what to do about it. Being "against HFT" without distinguishing between different forms of algorithmic trading obscures this important distinction.