Flash Crashes, ETFs & An Arbitrage Trader's Dream https://www.forbes.com/sites/rogeraitken/2016/08/30/flash-crashes-etf...
Flash crashes and rogue traders - there’ve been a few. Most trading folk will recall the May 6 ‘flash crash’ in 2010 - also known as ‘The Crash of 2:45’ or simply the 2010 Flash Crash. Yet has anything been learned since then or even last August’s ETF flash crash in the US? Perhaps, but there is always room for improvement even if there is no silver bullet or sacred cow on hand.
The events that unfolded in the US equity market on August 24, 2015, which followed the Treasury ‘Flash Rally’ on October 15, 2014, offered the first true opportunity to assess how effective reforms implemented in reaction to the Flash Crash of 2010 were. These measures spanned individual stock trading halts, policies to address erroneous transactions as well as the market-wide circuit breaker.
For the majority of the day late last August, the market performed adequately, functioned and remained accessible to investors and despite record trading levels and volatility.
That said, over the first hour of trading, a tumultuous US market open precipitated rapid, anomalous price moves in a plethora of stocks, exchange-traded products (ETPs) and closed-end funds. It underscores the point that volatility is never far away in markets and who knows when the next meltdown is coming.
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Contributing to the disruption that morning were a number of factors, as one might imagine. These included a confluence of US equity market issues that exposed structural flaws hampering the flow of order and price information, halted trading, and a held up the open for a wide number of securities.
Coming on the back of heavy and widespread selling pressure resulted in pre-market price falls in futures and a spike in market orders, with almost 50% of listed shares on the New York Stock Exchange failing to open by 9:40am on August 24.
Added to this volatile cocktail, the US equity ETP arbitrage mechanism was temporarily impaired as a result of disruptions arising from the above issues, which was not made any better by the excessive use of market and stop-loss orders seeking liquidity at any price.
2010 Flash Crash
Causing a trillion-dollar stock market crash apparently sparked by Navinder Sarao, dubbed the ‘Hound of Hounslow' who spoofed the market trading E-mini S&P 500 contracts out of a bedroom in west London, the 201o flash crash started at 2:32pm EDT and lasted around 30 minutes.
Major US stock indexes, such as the Dow Jones Industrial Average (DJIA), Nasdaq Composite and S&P 500, at the time collapsed and rebounded very swiftly that day. The Dow, for example, witnessed its biggest intra-day points decline - from the opening - up to that point, plunging 998.5 points (c.9%), largely within a matter of minutes, only to recover a large part of the loss.
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A report subsequently published in 2014 by the U.S. Commodity Futures Trading Commission (CFTC) based in Washington D.C., described the event as one of the most turbulent periods in the history of financial markets. Indeed, in dramatic conditions bids on a slew of ETFs and other securities had dipped as low as a penny a share.
Following the 2010 Flash Crash regulations were put in place. However, despite such actions it proved to be inadequate to safeguard and protect investors in a flash crash that occurred last year - August 24, 2015. This saw the price of many ETFs become unhinged from their underlying value.
Arbitrage Trader’s Dream Come True
Andrew Chanin, CEO at PureFunds based in New York who was at the firm during last August’s flash crash and prior to this an ETF trading company in May 2010, commenting says: “ETFs presented one of the greatest trading opportunities out there that day. Although many people were treating it like the May 6 ‘flash crash’ of 2010, it was clearly different.”
The Lessons & Industry Concerns
The former Cohen Capital Group director from 2009 to 2011, who plied his trade in ETF arbitrage, market making and prop trading across equities, fixed income, futures and options, adds: “Be careful with
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market orders and stop orders. Understand the crash better and the differences between these two occurrences.”
Meanwhile, Eric Ervin, co-founder, President and CEO of Reality Shares, an ETF issuer and index provider in San Diego that has created the first DRONE Stock Index, sharing his insight following in the wake of the one-year anniversary contends: “Some things have changed, but there are still many concerns and issues within the industry that need to be addressed to prevent a repeat scenario.”
He adds: “Not only are many analysts and experts apprehensive, but ETF companies themselves are continuing to point out that investors are vulnerable without sweeping changes.” The question here is what such changes may involve going forward and will they work.
A ‘Viewpoint’ paper from BlackRock (October 2015) on the US equity market structure and lessons from 24 August, states: “With the recognition that moments of high volatility and discontinuous pricing may be a persistent aspect of today’s markets, we see a need for market participants, exchanges, and regulators to improve the US equity market’s ability to cope with extraordinary volatility.”
Exchanges & Trading Halts
Among other issues, according to Ervin at Reality Shares in relation to exchanges there is a “need to address their procedures” for trading halts (including how securities are reopened after these halts). Furthermore, there needs to be “more consistency between the trading availability of ETFs themselves and their underlying holdings.”
He also posits that investors need “much more education and have greater awareness” about how these products trade in order to transact more appropriately. This echoes one of seven recommendations made by BlackRock in the aforementioned paper, namely educating investors as to how to navigate the modern US equity market.
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Along that vein the 16-page BlackRock paper states: “Customer-facing broker-dealers should consider whether there is more to do to raise investor awareness regarding usage of market and stop-loss orders in volatile periods, especially at the open or close.”
Enhancing US Equity Market Resilience
While it is true that ETF issuers and exchanges have already acted to reform the industry, Ervin contends that “regulators need to act with more urgency to avoid future problems”. This is especially so given the continued growing popularity of exchange-traded products, which spans ETFs and exchange traded commodities (ETCs).
According to the BlackRock view: “We believe that the industry and regulatory response should first focus on facilitating the free flow of pricing and order information across the US equity market ecosystem.”
And, the US investment house shared recommendations to refine trading mechanisms, citing “guard rails” to enhance the resiliency of the US equity market, which they contended would “promote fair and orderly markets and benefit the functioning of both ETPs and individual stocks.”
Their other six recommendations to enhance the resilience of the US equity market include: (1) Harmonizing trading rules among futures, options, individual stocks, and ETPs, with any new rules that should be designed consistently across the equity market ecosystem and its individual components; and, (2) Recalibrating the Limit-Up Limit-Down (‘LULD’) rules - applying a consistent price band throughout the day (instead of wider bands at the open and close) - recognizing linkages across markets and limitations of LULD during market-wide events.
Furthermore, they add into the mix, (3) Consider revising market- wide circuit breakers, and in doing so examine whether lower thresholds that would be tripped more frequently than the current
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thresholds “would enhance the market’s ability to respond under stress.” It was nevertheless pointed out that additional analysis was required in this area to determine the “appropriate thresholds”.
Subsequent to that there one could also contemplate: (4) Ensure transparency and timeliness of the primary market open - by extending automated pre-open imbalance data feeds until each stock opens when NYSE Rule 48 is in effect; (5) Eliminating uncertainty in the determination of ‘clearly erroneous’ trades; and, (6) Issuers of both ETPs and stocks, who “should be proactive in considering an exchange’s auction processes and trading rules before listing their securities.”
In particular on the last point, issuers should ensure that exchanges have procedures which promote fair and orderly markets in their securities.
The events of August 24 2015 certainly remind us - if we didn't need reminding again - that we live in a world of heightened and increasing volatility, with technology and many other dynamics impacting capital markets - ranging from equities to fixed income and beyond.
Dr John Bates, a pioneer in the fields of Big Data streaming analytics and the ‘Internet of Things’ with a PhD from Cambridge University, England, from where in the Cavendish Laboratory the atom was split in 1932 by Ernest Rutherford, observes it is highly unlikely that flash crashes will not happen again.
Having famously remarked in recent years that regulators were still using “bicycles to catch Ferraris”, Bates adds: “Although the circumstances and causes behind each [Flash Crash] are and can be different as witnessed through the May 2010 and August 2015 instances, the fundamental issue stems from the fact that capital markets are by their very nature aggressive with the pursuit of profits at their very heart.”
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As such, incidents involving rogue traders that may initially trigger such happenings are unlikely to go away any time soon, however much the regulators try to reform things and batten down the hatches. Bates further points to the “interconnectedness of markets” across the globe and between asset classes. So when financial market tsunamis do occur there is a knee-jerk reaction.
But as BlackRock's paper also argues, when it comes to proposed industry improvements they must “balance attempts to improve market resiliency” with preservation of existing and well-functioning processes by which equity securities are traded today.
They nevertheless acknowledge that there is no “silver bullet” or single solution to the issues observed last August. Recommendations put forward by BlackRock and others also need to be considered in a holistic manner if nothing else. But be careful what you wish for.
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