So says JP Morgan’s Michael Cembalest, who might well take an interest in the events of May 6.
As protectorate for “several hundred billion dollars in client assets,” the JPM private banking chief investment officer says he’s very interested in anything that might “detract” from market confidence. Which would be a rather reserved way of describing the May 6 ‘flash crash,’ which erased about $1,000bn in US equity in the space of minutes and for no apparent reason.
To that end, he names the “best things” to come out of the market disruption.
And here they are:
[1] Stock-specific circuit breakers. The U.S. has been slow to install circuit breakers on major exchanges, relying instead on “clearly erroneous trade rules” that cancel trades after the fact. In Asia and Europe, circuit-breakers have been around for a while. In Asia, trading is restricted outside of pre-specified daily bands of 5%, 10% and 15% (different by market). In Europe (e.g., Deutsche Bourse), trading is halted for 5 minutes after a 3%-10% move, and then reopened. In the wake of the Flash Crash, 10% circuit breakers are now applied to a few stocks as part of a pilot program (they have already been triggered on Citigroup, Anadarko and the Washington Post Company). If we are going to exist in a world with automated robots doing the lion’s share of daily trading, circuit breakers may be needed to prevent unintended and unmanageable meltdowns.
Another topic under discussion by the SEC: prevent [high-frequency traders - HFTs] from having “unfiltered, naked access” to the exchanges by requiring them to live by the same pre-trade risk management controls that clearing members do. Why? As noted by the Chicago Fed, “high-frequency trading has the potential to generate errors and losses at a speed and magnitude far greater than that in a floor or screen-based trading environment”.
[2] More balance to the HFT discussion. HFT supporters claim they are providers of liquidity to the market, and that HFT makes U.S. markets more efficient than ever. Suggestions to the contrary have been deemed “utterly laughable” by firms defending them (see Rosenblatt in sources). However, the Flash Crash highlights the uncertainties around these assertions. While volumes have tripled in the last few years, there’s a big difference between volume and liquidity (the ability to transact without moving the price). In an industry barometer survey conducted by the Tabb Group in May of this year, barely half the participants had a high degree of confidence in the US equity market structure; 73% did not believe the market structure is “orderly”. One of the survey recommendations: HFTs should be required to register as broker-dealers.
To be sure, there were weaknesses in the old specialist system as well. But specialists were required to maintain a fair and orderly market, and post quotes that were part of the National Best Bid and Offer system; their reputations mattered. HFTs have no such requirements (no minimum shares or minimum quote times); one proposal would require quotes to be valid for at least one second. The SEC has broadened the trader reporting system in order to analyze HFT activity more closely
[3] Proposals requiring HFTs to act more like the floor specialists they’re replacing. With the advent of HFTs, cancelled orders have soared. Today’s ratio of 30 cancelled orders for each one executed means that 97% are cancelled. To curb abusive practices, some market participants recommend applying a fee to HFTs for an excessive number of cancelled orders. The increase in cancelled orders is one reason we do not agree that increased order depth on S&P 500 stocks at the NBBO is a clear indication of greater liquidity, as some market research alleges. Quotes pulled within a nano-second of being posted, and which are part of an algorithmic order detection exercise, don’t seem like liquidity in the traditional sense. Ameritrade’s representative on the recent SEC Roundtable referred to this as “opportunistic liquidity”.
[4] More discussion around HFT “co-location”. Some HFTs co-locate computer servers inside stock exchanges3 to minimize the milliseconds (or nanoseconds) required to scan existing orders, and have algorithms act on this information. As trading execution and IPO listing fees declined, exchanges have tried to make up the difference by selling access to market data. Some exchanges have products which give clients a faster look at quotes, in exchange for a fee. As a result, some HFTs end up with access to information sooner than institutional or retail investors who rely on more standard venues (such as SIP Quotes).
The search for co-location benefits has existed forever (in polite company, “order anticipation strategies”). Broker-dealers in past decades argued that being closer to floor traders on the CBOT was an advantage to their clients. But historical parallels can lose their meaning when the instruments of battle change: one HFT computer can reportedly decode more than 5 million messages per second. The Flash Crash has increased the debate around whether co-location confers advantages to HFTs, and whether there should be obligations and responsibilities that accompany them.
[5] Asset managers learn that “cheapest <> best”. After the NYSE moved to decimalization in 2001, bid-offer spreads fell almost in half on S&P 500 stocks (less so for the Russell 2000 stocks, where HFTs are less active). Schwab retail commissions fell from $35 in 2003 to less than $10 in 2009. This trend is confirmed by broader research from the American Association of Individual Investors. So if the prism of success is bid-offer costs and commissions on individual trades, the battle has been won.
But is that the right prism to define what makes an optimal marketplace? Part of the HFT industry tracks the order flow of larger investors who leave electronic footprints4. Using algorithms which include spraying the tape with thousands of quotes, the intentions of large investors is ferreted out. This can result in higher trading costs for such investors, and by extension, their clients, who include 401k investors, and pensioners participating in state and corporate plans. Quantitative Services Group computes analyses of HFT impacts on execution costs. They estimate that HFT tracking algorithms can drive execution costs up 1.5 to 3 times, even when institutional investors parcel trades into smaller orders to avoid detection.
One last point on the Flash Crash. At a June SEC Roundtable dealing with the crash and market structure, the CEO of Vanguard proposed “depth of book” protection. In plain English: customer orders should get the benefit of the best bids and offers at multiples prices across exchanges, rather than just the single best quote on one exchange. With the average trade size having fallen by 70% in the last few years, only protecting the single best bid/offer has become less meaningful. A “depth of book” rule might prompt traders to post more limit orders and reduce volatility, a view shared by the Tabb Group survey respondents.
So the silver lining to the May 6 crash then is basically that — much like the Sergei Aleynikov story of last year — it’s focused attention on what are still new-ish and not very well-understood market developments.
As he puts it:
High frequency trading is here to stay, and parts of the industry contribute to greater efficiencies. But the HFT industry may have gotten ahead of anyone’s ability to understand and monitor its capabilities and consequences. The combination of a singular quest for lower execution costs and advanced technology may have resulted in a more fragmented marketplace in which liquidity is temporal, and in less incentive to display limit orders or contribute capital to market-making. The Flash Crash provides a basis for regulators and market participants to consider these consequences in more detail than they have so far, and make adjustments.
Well said, Mr Cembalest.
The full note available in the usual place, or the not-so-usual ZeroHedge.
Related links:
Quant-ifying the HFT effect in stock movements – FT Alphaville
HFT and the demise of mega fauna – The Reformed Broker
BarCap on that flash crash: ‘a perfect storm’ – FT Alphaville
Vital lessons of the ‘flash crash’ – FT