Regulators, politicians, media types, investors and exchanges are still trying to figure out just what happened to cause that sharp, sudden and scary plunge on Wall Street last Thursday.
Now analysts at Barclays Capital have weighed in:
Last Thursday’s market action, in our opinion, did not begin and end with trading errors and/or exchange technology failures. Nor, as some commentators are suggesting, were quantitative trading strategies primarily responsible for the events that unfolded. All of these forces may have contributed to the voracious sell-off, but our analysis suggests that last Thursday’s events were more a function of a “perfect storm,” to borrow a cliché phrase.
The trading day got off to a bad start with markets down 2%-3% on macro concerns about European sovereign debt risk…By late morning, in fact, the percentage of NYSE-listed volume trading on a down-tick at the same time had approached levels not seen since the morning trading resumed after 9/11. In other words, there was already a lot of fundamental selling pressure in the market, and we believe the rising risk aversion of investors did not need much of an acceleration in the sell-off to run for the exits.
On NYSE:
From an exchange perspective, with the backdrop of market fundamentals and technicals already being negative, NYSE-listed stocks started to hit little-known circuit breakers called liquidity replenishment points (LRPs) in large numbers. Whether a “fat finger” error trade in the S&P futures market or something else triggered a gap down in stock prices remains a topic of debate, but nonetheless the LRP-levels were reached.
On HFT:
The market structure in US cash equities trading has evolved over the past few years to depend heavily on high frequency algorithmic trading entities which behave like “pseudo market makers”. These trading entities populate exchanges with limit orders (liquidity) that result in rebates as exchanges pay for participants to provide this liquidity; the trading entities also capture bid/ask spreads on the stocks they trade. This works well during periods of normal market activity, as these firms can execute their models without taking directional market risk. However, these firms are not obligated to post bids and offers – in other words, they have no responsibility to make markets.
In Thursday’s volatile market conditions, we believe that much of the liquidity provided by these trading entities disappeared as these traders sat on the sidelines. What drove them out of the market was most likely a combination of two factors. As the markets moved sharply downwards and then sharply upwards, it was most likely extremely difficult for these traders to put on a “hedged position,” that is, not to be taking directional market positions. As this is not their strategy, they almost surely backed away from the market entirely. Additionally, in conversations we have had with managers of these trading operations over the past several days, they have voiced a reluctance to participate in disorderly markets like we experienced on Thursday out of fear that some of their trades will end up being cancelled. In particular, as they run a hedged book, they worry most that only one half of their trades will be cancelled by the exchanges, leaving them ex-post with an unhedged book. This concern – which in retrospect appears justified – further contributed to their moving to the sidelines.
The net result was that during the period of heightened market volatility, these trading entities were not active in the market and that there were few fundamental buy orders to take their place given the risk-aversion discussed above thus leaving little price support in place.
And an ‘are you listening?’ to regulators and lawmakers:
In the context of the broader discussion around mandated trading of OTC derivatives, we note that even the most transparent, commoditized and technologically advanced market (US equities trading) is not without shortcomings – shortcomings that were difficult to avoid even after a long and exhaustive regulatory process that ultimately resulted in Reg NMS. Observing the hurried process being undertaken by Congress to legislate OTC derivatives trading and clearing with a very short implementation time horizon concerns us and should be a signal that market micro structure can have very real impact on wealth creation and destruction that ultimately can carry through to real economic activity.
Full note in the usual place.
Related links:
‘Wild week’ leaves big questions – FT
Flash Crash Four Days Later: Few Answers, Many Suspects – WSJ Deal Journal
Blame the trading bots – again – FT Alphaville
ETFs and the ‘flash crash’ – FT Alphaville