So what was the cause of the ‘flash crash’

I got into a bit of trouble yesterday, as various colleagues told me that the discussion on the flash crash was inaccurate and full of errors. A key issue was the discussion of flash orders being part of the problem as, apart from a rare exception such as Direct Edge, flash orders no longer exist in the US markets.

What is Direct Edge?

“Direct Edge, America's newest stock exchange, offers the next generation of displayed markets. With U.S. cash equities volume routinely exceeding 1 billion shares per day, Direct Edge uses multiple platforms and unique order types to match complementary forms of liquidity based on sensitivity to transaction cost, fill rate, and fill speed, while maintaining high execution quality and low latencies. Our innovative business model creates opportunities for the trading community unlike any other market centre. This is what the future of trading looks like.”

Direct Edge argues “that flash trading reduces market impact, increases average size of executed orders, reduces trading latency, and provides additional liquidity ... (as a result) NASDAQ and BATS created their own flash market in early 2009 in response to the Direct Edge market. Both voluntarily discontinued the practice in August 2009. The Securities and Exchange Commission in September 2009 proposed banning the practice as part of regulatory reforms in the wake of the Financial Crisis of 2007–2010. As of May 2010, the proposals have not been implemented. Even though most programs have been stopped voluntarily, it is still possible, at least with Direct Edge.”

Yea right. To be honest, Direct Edge may have promoted flash orders in the past, but they will be forced to adapt and eradicate such practices by the SEC, as they are now Regulated Exchanges in the same category as NYSE, NASDAQ and BATS.

Even if Direct Edge did contribute to the market issues, I was told that this would not mean that they would have had any impact on the flash crash, as they would only be able to flash trade their own order book.

Hmmmm ... another point was made that, for the US markets in general, all orders are seen by everyone before they are filled. This is definitely not true in Europe as pre-trade transparency is what everyone is fighting against. That’s the point of Dark Pools: to enable block trading to be achieved unseen. After all, if you’re going to trade millions in an equity such that the price moves, the last thing you want is for the markets to know this BEFORE trade execution.

I am interested to hear more on this as the comment implies that the US markets are moving towards, or have already achieved, pre-trade transparency whilst Europe is struggling to achieve any form of transparency (more on this later in the week).

Meanwhile, it also contradicts the FT who reported yesterday that:

“Spoofing, layering and front-running ... strategies for market manipulation may be long-established – but the May 6 “flash crash” has given a fresh sense of urgency to US regulators’ efforts to crack down on the abuse. An inquiry into the crash has yet to pinpoint any definitive cause. But the regulators’ review has focused attention on the substantial growth in high-frequency trading and its use of computerised trading programmes – algorithms – to profit from fractional price differentials.”

This was followed up today by saying that “BM&FBovespa, Brazil’s multi-asset exchange, is introducing a new limit on asset price fluctuations of more than 15 per cent in any given day.”

So here’s one key point.

Regulators are creating rules that limit price fluctuations to avoid another flash crash, and these are likely to be copied worldwide. For example, the SEC introduced a rule in June that a stock movement of more than ten percent in any five minute period will stop trading in that stock, and now Brazil has followed suit.

However, these rules (a) would not necessarily have avoided a flash crash; (b) does not discover the real cause of it; and (c) does not recognise that, if it is due to market abuse, then it’s not the systems that caused the problem but the traders.

This last point is the key, as my algo tech friends tell me that machines don’t cause the issues but the way you program them.

Obvious.

So why shut down, attack or undermine High Frequency Trading (HFT)?

Instead, the SEC should shut down and attack the cause of the irrational movements. If these were system generated, it should then plug the programming error that allowed it – a simple fix such as halting trading if stocks move irrationally too quickly – but then they need to find the people who did the programming and discover their intentions. If the intention of the traders who created it was for market abuse, then that’s where the issues really lie and that’s what the SEC is trying to disover.

Meanwhile, if it’s not flash orders or HFT that caused the crash, then what is the real cause?

My American friends tell me it’s LRP, the Liquidity Replenishment Point.

The New York Stock Exchange (NYSE) has various LRP points to ensure that algorithms cannot go nuts and send markets into freefall, and yet this is what happened on May 6th.

So how could it happen?

Well, LRPs only work on NYSE and NASDAQ, but now there are BATS and Direct Edge. This is therefore how the issue could arise and was discussed in depth by Bloomberg the day after the crash:

“More than 29.4 billion shares changed hands in U.S. markets yesterday, the most since October 2008. In addition to traditional exchanges such as the NYSE, rivals Bats in Kansas City and Jersey City, New Jersey-based Direct Edge Holdings LLC handled millions of trades. About 2.6 billion shares traded on the NYSE, the lowest level relative to overall volume in three years, data compiled by Bloomberg show.

“Rapid-fire orders trigger what the NYSE calls liquidity replenishment points, or LRPs, shifting trading into auctions overseen by market makers. While the system is designed to restore efficient trading on the Big Board, selling is so fast during times of panic that orders routed past the exchange may swamp other venues and exhaust buyers, said James Angel, a finance professor at Georgetown University in Washington.

“That’s when prices may plummet as orders execute against so-called stub quotes. Brokers can set those as low as a penny a share because they’re never expected to be used. ‘In a situation where only one market stops trading, not only does it not help, it likely exacerbates the situation,’ said William O’Brien, CEO of Direct Edge, which was founded in 2005. ‘Yesterday is a day that no exchange should be proud of.’

“Increasing automation and competition have reduced the NYSE and NASDAQ’s volume in securities they list from as much as 80 percent in the last decade. Now, less than 30 percent of trading in their companies takes place on their networks as orders
are dispersed to as many as 50 competing venues, almost all of them fully electronic. Twenty years ago, fewer than 10 exchanges competed for all U.S. equity trades.

“The replenishment points are triggered regularly on the NYSE and promote efficient trading, according to Ray Pellecchia, a New York-based spokesman.‘Today you’re hearing about it because of the magnitude of the fall,’ Pellecchia said. ‘Usually it’s not a market-wide move, it’s just a small group of stocks.’”

All well and good.

So here’s my challenge: if Bloomberg could give such a good account of the flash crash the day after it happened and attributed it to LRPs, then why is the SEC looking into spoofing and layering four months after the event?

Equally, you cannot say Direct Edge and their flash orders have no impact on markets other than their own, as the above shows the interlinkage between BATS and Direct Edge with NYSE and NASDAQ. As liquidity platforms they affect price movements and executions with the other Exchanges such that, if the order isn’t filled on NYSE due to Direct Edge having a better price, then the order is filled on Direct Edge through smart order routers. This affects NYSE’s liquidity and brings in the issues of LRP. So that does imply that Direct Edge allowing flash orders could impact LRP through their order flows on algorithmic smart order routers between NYSE, NASDAQ and BATS, and hence possibly cause a flash crash moment.

Now I know this is complex – it’s doing my head in - so gawd knows what it’s doing to the SEC, but it is clear that there is nothing simple about the causes of the flash crash and, until discovered, I would be very wary of making it a simple blame attribution to one cause – HFT – or another – LRP.

This is Part Two in a Series of Posts on the Regulatory Agenda for Capital Markets:

• Part One: SEC to crackdown on HFT?
• Part Two: What was the cause of the 'flash crash'
• Part Three: Exactly what is and how big are 'dark pools'?
• Part Four: MiFID II - the post-trade agenda
• Part Five: Best Execution and Global Trading

These items also build upon a series of posts about the Deutsche Börse:

• If you can't afford the tech, get out of the market
• Circuit
  breakers on the Deutsche Börse
• Forget
  Frankfurt, I'm moving to Basildon