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Flash Crashes, Systemic Risk, and the Demise of Investor Value Investing

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Flash Crashes, Systemic Risk, and the Demise of Investor Value Investing THE MAGAZINE OF INTERNATIONAL ECONOMIC POLICY 888 16th Street, N.W., Suite 740 Washington, D.C. 20006 Phone: 202-861-0791 • Fax: 202-861-0790 www.international-economy.com [email protected] The B Y H ARALD M ALMGREN AND M ARK S TYS Marginalizing of the The inside story of Individual flash crashes, systemic risk, and the demise of Investor value investing. n May 6, 2010, at about 2:30 p.m., data center which encompassed the disaggregated reporting a “flash crash” in the U.S. stock systems of nine separate U.S. exchanges, the dark pools, market sent the Dow plummeting and the activities of new ultra-fast, computerized high- by almost 999 points—the deep- frequency trading platforms. Theoretically, it could take est intraday plunge ever recorded. months to run the day’s records in ultra-slow motion to iden- From 2:45 p.m. to 3:00 p.m. the tify market malfunctions or possible manipulations. The Dow recovered by about 600 SEC does not have the manpower or technical capability to points. During the flash crash, carry out such a challenging task. some individual stocks collapsed to pennies and then Faced with unprecedented challenges, the SEC resorted Orebounded. For the day as a whole, the market closed down to its traditional and only immediate regulatory remedy of about 350 points. setting new circuit breakers for individual stocks. Then it This unprecedented shock galvanized the Securities and proposed adding a requirement that broker-dealers restrict Exchange Commission into action to identify the cause and quotes to within a specified range around prior trades. devise mechanisms for preventing recurrence. At first, it was Circuit breakers may help reduce the impact of potential thought that a “fat finger” error might have sent computer- breakdowns in specific stocks, but they cannot prevent recur- ized trading into a tailspin. However, it soon became evi- rence of massive disruptions in exchange-traded fund trading. dent that the scale and speed of trading abnormalities could According to Barron’s, ETFs were responsible for about 70 not have been the result of a single misplaced finger. To its chagrin, the SEC found its antiquated computer capabilities Harald Malmgren is chief executive officer of Malmgren could not begin to capture the volume and speed of trans- Global, and Mark Stys is chief investment officer of actions in today’s markets. Moreover, there was no coherent Bluemont Capital. 22 THE INTERNATIONAL ECONOMY SUMMER 2010 M ALMGREN AND S TYS Ten years ago, it had already been recognized that trading based on computer algorithms probably accounted for about half the total trading volume in the U.S. markets, and dominated the trading practices of major institutional investors. Since then, technology has accelerated, with high-frequency trading platforms ramping up the speed to milliseconds and more recently to microseconds. percent of all the May 6 flash crash trades that were later collapse of the entire equity market. What happened that cancelled by the exchange. ETFs are a small percentage of day is that some high-frequency traders did disengage from securities traded on the stock exchanges, but they were a markets, turning off computers which seemed to their oper- major factor as liquidity faded away and the ETFs them- ators to be conveying misinformation. selves became decoupled from their underlying baskets of Recognizing the inadequacy of available information, stocks, while the prices of some specific stocks swung wildly. the SEC has now started developing a new reporting sys- Most important, circuit breakers are of no significance tem known as the Consolidated Audit Trail. This system is if a large-scale implosion of liquidity results from suspension intended to bring all of the presently disaggregated, frag- of trading by high-frequency traders, threatening systemic mentary data into one place to enable “real-time surveil- lance.” Development of the CAT is expected to require at least $4 billion to build, take three years to complete, and require $2 billion per year to operate. Long before CAT is a At first, it was thought that a “fat finger” reality, there are likely to be more crashes. Moreover, there can be doubt whether real-time capacity could ever be achieved given the complexity of high-frequency trading error might have sent computerized “flash trades” (execute or cancel on receipt) in which a high ratio of bids automatically self-destruct. By the time CAT is finished, technology will have spread globally, posing trading into a tailspin. However, it unforeseeable jurisdictional information disclosure issues as well as new technological challenges. Ten years ago, it had already been recognized that trad- soon became evident that the scale ing based on computer algorithms probably accounted for about half the total trading volume in the U.S. markets, and dominated the trading practices of major institutional and speed of trading abnormalities investors. Since then, technology has accelerated, with high- frequency trading platforms ramping up the speed to mil- liseconds and more recently to microseconds. One of the could not have been the result of high-frequency trading CEOs stated that the longest duration of holding a given stock by his firm was eleven seconds, although he considered that to be unusually and unaccept- a single misplaced finger. ably long. The combined role of computerized algorithms and high-frequency trading activities varies in intensity during SUMMER 2010 THE INTERNATIONAL ECONOMY 23 M ALMGREN AND S TYS the course of any trading day, but during some time intervals taking place in the “dark pools” of privately arranged trans- may account for more than 80 percent of total trading vol- actions. They are also able to initiate large arrays of “flash ume. High-frequency traders interact with the vast array of orders” to ascertain the depth and breadth of the market, and algorithms employed by large financial institutions, acting identify if there are willing buyers at some level above most like a turbo booster. Consequently, the volume and speed of recent trades. Flash orders are small “immediate or cancel” bids and asks has been growing exponentially. orders, valid only for microseconds, that carry little risk for High-frequency trading has revolutionized how stock high- frequency traders. By ferreting out buyer limits, high- markets function in the United States. High-frequency trad- frequency traders have vastly greater knowledge of all ing enterprises argue that they provide substantially increased aspects of the markets’ depth and breadth than individuals or liquidity to stock market trading, and that they improve effi- passive investors like pension plans. ciency by driving down buy-sell spreads to tiny fractions of High-frequency trading also allows for exchange or the spreads that prevailed a decade or more ago. Such argu- market arbitrage. At present, there are nine separate U.S. ments initially sound appealing, especially to economists exchanges that route orders to New York Stock Exchange- dedicated to “efficient market” hypotheses. However, high- listed stocks: the New York Stock Exchange, Nasdaq, BATS, frequency trading liquidity turns out to be illusory, totally Arca, the Chicago Board Options Exchange, the dependent on the willingness of high- frequency trading plat- International Securities Exchange, the Chicago Mercantile forms to remain active under all circumstances during all Exchange, the Boston Stock Exchange, and the Cincinnati trading hours. When several high frequency traders disen- Stock Exchange. Each makes bids and offers, with differing gaged from the markets on the afternoon of May 6, the result speeds. In pursuit of the highest possible bid, or National was a temporary implosion of liquidity. This greatly aggra- Best Bid, and the lowest offer, or National Best Ask, high- vated the dysfunctionality of markets during the flash crash. frequency traders can exploit not only differences in prices What has been learned from this event is that high-frequency but also differences in response time. For example, the trading platforms not only can enhance market liquidity, but NYSE typically runs slower than trading on BATS. This they can also threaten massive meltdown, or systemic risk. provides opportunity for time arbitrage. It is possible to surge The May 6 flash crash event demonstrated that a prolonged, orders through the NYSE (some call this “quote stuffing”), total market shutdown could occur if some or all high-fre- forcing a slowdown of a few seconds in trading, while estab- quency traders abandoned trading. lishing a price in BATS which is then routed to the NYSE. High-frequency trading platforms essentially make Thus, with numerous venues for execution and ability to profits by extracting a tiny fraction of every transaction, but transact in all of them, high-frequency traders can take generating volumes of trades at speeds never imagined a advantage of bid and offer differentials across exchanges. decade ago. They thrive on a combination of asymmetric NANEX, LLC did a study of the May 6 flash crash and information advantages and extremely short-term profit found evidence that this occurred starting on the NYSE at objectives. Because of their high volume of activity, high- 14:42:46 and spread to over 250 stocks within two minutes. frequency traders are able to acquire information on trades This type of cross-market arbitrage is not the kind of liq- uidity that adds value, but instead skews price to the advan- tage of the high-frequency traders. High-frequency trading tends to be more profitable Because of their high volume when markets are rising so that the bid-ask spread is maxi- mized as high-frequency traders fill any gap between buyers and sellers. In falling markets, high-frequency trading tends of activity, high-frequency traders are to be less profitable, as sales of purchased shares become more difficult in a falling price environment and extra cost is entailed in financing short positions.
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