Last year, when the U.S. Securities and Exchange Commission came out with its final report on the flash crash, the stomach-churning event of May 6, 2010, that wiped $1 trillion of value from the markets in less than 30 minutes, it never managed to explain why the episode happened.
The good news is, people are still studying the situation. One of the most illuminating recent analyses comes from Andrew Haldane, the Bank of England’s executive director for financial stability. High-frequency trading, he says, really is making the market less stable, and for understandable reasons. Unfortunately, identifying what is happening appears to be more straightforward than figuring out what to do about it.
High-frequency trading now accounts for almost 75 percent of all buying and selling of U.S. equities, and a race to trade even faster is under way. The technology to trade thousands of times per second has existed for several years, and it won’t be long before that rate is pushed to a million. The fastest exchanges are now executed in about 10 microseconds — the time it takes a jetliner flying at full speed to travel one 10th of an inch.
An informal study by the New York Times, reported a few weeks ago, found that single-day share-price changes as large as 3 percent to 4 percent are now more likely than at any other time in recent stock-market history. Academic studies show much the same thing: In the past six years, large and volatile movements in stock prices over periods of 15 minutes or so have become much more common.
Here’s why. The bid-ask spread is largely set by traders who act as so-called market makers. They don’t speculate on price movements, but simply stand ready to take either side of a trade, and aim to profit from the spread. Market makers can reduce spreads to attract trading, but they can’t go too far because they face risks — for example, that a stock they buy might lose value before they can sell it. Ultimately, the bid- ask spread reflects how much market makers have to charge to take on such risks and still be profitable, while making it easier for everyone else to trade when they want.
Importantly, Haldane points out, the risks that market makers face grow with the likely size of price movements. In increasingly volatile periods, high-frequency market makers have to charge more because they get burned more often by unexpected movements. Hence, it’s quite natural to expect a market maker, during an episode of market chaos, to widen its bid-ask spreads, sometimes drastically.
And this brings us to the main point — that it’s the sudden evaporation of such liquidity that propels events such as the flash crash. All in all, then, it seems likely that the very high-frequency trading that makes the markets run so smoothly in quiet times does the opposite in stormy times, exaggerating the chaos.
NeilS – I never thought I’d say that I’m getting used to 3% daily swings in the Dow, but it certainly seems like the “new normal”. Yesterday, for example, the Dow rallied nearly 4% in a mere 45 minutes near the end of the trading day. If the Dow is a benchmark for the U.S. economy, it is flabbergasting that it can swing 3 or more percent on any given day while our GDP clunks along at anemic ~1.3%. Nevertheless, the reality is in the numbers. 75% of trades are now done through high frequency trading algorithms and there are no broad-based fail-safes. Certainly the “flash crash” is a testament to the chaos that can ensue when nobody is overseeing the system and pure computer algorithms are responsible for our entire economy.
Being in the trading business myself and playing the role of a market maker a times, I can attest to the fact that the cost of doing business on the bid/ask spread is much higher than it used to be. With increased volatility and more computerized trading, it seems like the market doesn’t take much time to think over what it wants to do, it just has a pre-programmed agenda and it tries to follow it to its logical conclusion as quickly as possible. Of course, that makes the role as a large liquidity provider much more difficult, and in turn volatility begets more volatility as market makers pull their bets when things get wacky. All in all, it seems like the wild ride in the markets is not over and we should all be prepared for any outcome no matter how absurd it may seem. - Source
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