Transcript Slide 1

Did HFTs cause the Flash Crash?
What are HFTs?
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.
Source: CFTC and SEC Preliminary Findings Regarding the Events of May 6, 2010
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.
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
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
Source: CFTC and SEC Preliminary Findings Regarding the Events of May 6, 2010
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
Source: CFTC and SEC Preliminary Findings Regarding the Events of May 6, 2010
Source: CFTC and SEC Preliminary Findings Regarding the Events of May 6, 2010
Source: CFTC and SEC Preliminary Findings Regarding the Events of May 6, 2010
Source: CFTC and SEC Preliminary Findings Regarding the Events of May 6, 2010
Source: CFTC and SEC Preliminary Findings Regarding the Events of May 6, 2010
Source: CFTC and SEC Preliminary Findings Regarding the Events of May 6, 2010
Source: CFTC and SEC Preliminary Findings Regarding the Events of May 6, 2010
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 23rd and June 29th 2010.
– 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.