On May 6, 2010 the Dow Jones Industrial Average dropped almost 1000 points in a matter of minutes and just as quickly recovered most of the losses. Over the next two years, numerous mini-flash crashes have occurred in the trading activity of individual stocks. These perturbations, though reported in the financial press, did not draw much public attention because the damage was brief and limited in scope. The sporadic gyrations induced in a handful of stocks by high frequency algorithmic (HFA) trading were largely dismissed as anomalies. However, over the past year or so, the trading imbalances in both individual stocks and the overall market have increased with sufficient frequency as to cause deep concern among market participants and regulators. Notable fiascos include the disastrous rollout of Facebook shares on May 18, 2012, the roughly one half billion dollars in trading losses within a matter of minutes by Knight Capital on August 1, 2012, and the halt in NASDAQ trading for about three hours on August 22, 2013. As these glaring market events occur with greater frequency and duration, the outcry for a permanent solution gets louder and louder. More disconcerting is the lack of satisfactory explanations as to what caused these unusual occurrences, other than the fact that they all involved HFA trading. In fact, well over half of the trading volume on U.S. market exchanges involves high frequency trading. Therefore, it is quite natural to question the practice of HFA trading as it relates to market integrity, or lack thereof, when such trading aberrations occur.
More and more investors believe our markets are rigged in favor of large Wall Street firms, who have the resources and reliable government connections to employ high-speed computers and proprietary algorithms to their advantage through manipulative HFA trading. Honest investors and retail traders believe they are being preyed upon 24/7/365 in what is supposed to be a fair and open marketplace while market regulators look the other way, through either incompetence or, worse, through the quid-pro-quo revolving door between Wall Street and the federal government. Wall Street banks regularly report unbelievable consecutive profitable trading days quarter after quarter, which is statistically impossible unless they are cheating. Yet, government regulators don’t see anything unusual with such results. No wonder investors have little faith in our markets. It’s no surprise that polls consistently show the approval rating of our government officials nearly in single digits. Taking into account the margin of error, the U.S. Congress is batting zero with the public.
These disturbing events set in motion a series of conversations among public officials and HFA traders. Although these discussions did not actually occur, they serve to illustrate the mindset of the parties involved, as perceived by jaded market observers. All of the conversations share the elemental human emotion of high anxiety. The angst stems from the uncomfortable realization that the problems cannot be swept under the rug any longer. The tremor felt during the flash crash of May 2010 was not a one-off event and everyone knows it. Instead, it appears in retrospect to have been the first warning sign of an earthquake that will ultimately rock the financial world. There is a big difference between a natural disaster and a man-made disaster. A man-made disaster is avoidable and can be corrected in most cases once the problem is identified. The question is whether man has the courage and wherewithal to take the necessary corrective action. The growing fissures in trading activity indicate latent brittleness and instability in the market infrastructure. The root of the problem remains. The implications for our capital markets are a real and present danger. Next time, a market crash may not be a temporary phenomenon.
The regulators, the president and the traders discuss the problem. Let’s listen in.
In the wake of periodic market instability, senior managers gather in the war room at the Securities and Exchange Commission. The mood is tense. A few days earlier, NASDAQ trading was halted for about three hours. Because of the May 2010 flash crash and other trading anomalies since then, the financial world is ill at ease. The SEC claims it was completely blindsided. The media are demanding answers and want them yesterday. In the room are people who represent a broad spectrum of disciplines. These include a securities law specialist (lawyer), an ex-Wall Street executive (wise guy), an ambitious by-the-book regulator (enforcer), and a political operative from the White House (politician). Here are snippets of their conversation.
Politician: Needless to say, the White House has been inundated with angry phone calls and emails wanting to know what is causing the spate of trading irregularities in our financial markets. The Press Secretary is doing his level best trying to deflect questions from the media but he cannot hold them off forever. Our fragile economic recovery cannot withstand such nerve-wracking disturbances in our capital markets. We need answers and we need them quickly. What the hell is happening?
Lawyer: The SEC has convened a board of inquiry to investigate the matter. We have early indications that a fat-finger trader from the NYSE Arca inundated NASDAQ computers with an avalanche of orders, which precipitated a temporary dislocation in market activity. This is eerily similar to how a large sell order from a firm in Kansas back in 2010 caused a huge trading imbalance, which led to infamous flash crash.
Enforcer: We know much more than that. Our people have known for years that the unbridled growth of unregulated high frequency algorithmic trading has created conditions that are ripe for the type of crash that occurred on May 6, 2010 as well as subsequent market glitches. It was an accident waiting to happen then and it still is. We believe that traders are using HFA trading to game the market each and every day through market manipulation. One only has to look the statistically impossible string of consecutive profitable trading days to know they are bilking investors. Yet, we are told to stand down. High frequency trading is off-limits. For chrissake, we still haven’t banned high frequency peek-a-boo trading, commonly referred to as flash trading. High-speed traders get to see bid and ask prices before everyone else and are allowed to trade on that inside information to the tune of tens of millions of dollars in profits each trading day. This is the very definition of cheating. Everyone thinks Wall Street owns us. Who can blame them? Are HFA traders at the big banks and hedge funds too big to bust?
Wise Guy: Listen, these unfounded accusations simply feed into a frenzied paranoia among investors, which itself unsettles the market. High frequency trading provides needed liquidity to our capital markets by narrowing the spread between bid and ask prices. Everyone benefits.
Enforcer: Yeah, everyone on Wall Street. Any perceived narrowing between bid and ask prices is gobbled up by HFA traders who manipulate prices to their advantage. Investors pay more for their shares and the HFA traders bag the difference. It is tantamount to an undeclared tax on each transaction. The so-called liquidity that HFA trading creates is ephemeral and will flee the market in a heartbeat just as it has done numerous times when a trading imbalance in individual stocks is detected. When that happens on a large scale, the market crashes. It can happen at any time and next time it may not be a temporary phenomenon. With control of half the volume, HFA traders have effectively cornered the market.
Wise Guy: That is sheer alarmist rhetoric and has no place in this discussion. HFA trading has been going on for years and now you are suggesting that we shut it down. We will be run right out of town for gross incompetence.
Politician: Gentlemen, can we stay on topic? First, we need a thorough examination of why these disturbing events are occurring. Second, the White House is deeply concerned that this might happen again. If so, it wants to be prepared.
Lawyer: That is exactly why we have enlisted the services of Wall Street experts to assist us in our investigation. After all, who is better equipped to explain the intricacies of high frequency trading and how it reacts under such conditions?
Wise Guy: Excellent move.
Enforcer: So let me understand this. We are going to have the fox help us investigate its break into the hen house. The SEC is perfectly capable of tracking trading patterns to determine exactly what occurred and why it occurred. It would be easy for us to prove that these firms are using algorithms to manipulate the markets to their advantage. We can also determine exactly how this type of activity makes our capital markets vulnerable to a crash during a dislocation. The integrity of the marketplace is at stake. We still have time to shut down or seriously curtail HFA trading before it’s too late.
Wise Guy: That kind of talk is insane and irresponsible. It sounds like you have made up your mind without one shred of evidence of any wrongdoing.
Politician: O.K. Let’s get to bottom of the various incidents first. It is perfectly reasonable to have Wall Street experts assist in the investigation because they can offer resources and expertise that we lack, especially as it relates to such complicated trading activities. When can we expect a draft report on this matter?
Lawyer: It will take a few months. In the interim, the SEC has decided that the installation of circuit breakers on our exchanges should be sufficient to mitigate and limit any exposure to another flash crash, if one happens again. After our report is delivered, we will convene a committee to look into HFA trading activities in more depth to determine whether any further action is necessary.
Enforcer: I do not detect any sense of urgency. Am I correct?
Politician: This meeting is adjourned. In the meantime, it is business as usual. Frontline regulatory enforcers shall take no further action on this issue until we receive the final report and review its recommendations.
Such is life at the SEC. The delicate matter is left in the capable hands of a politician, a lawyer, and a wise guy, all of whom represent the interests of Wall Street. The enforcer is told to back down because he is not a team player. He does not understand that wise guys always win.
Shortly before the joint report of the SEC/CFTC is released to the public, a meeting is held in the Oval Office of the White House. In attendance are the President, the Vice-President, the Secretary of the U.S. Treasury, and the Chief Economic Advisor. The President had been advised that the issue at hand is of grave national importance and concerns certain conditions in our capital markets that could potentially lead to the instability of our financial system. Here is their conversation.
President: Gentlemen, I understand that there are latent problems within our marketplace that could de-stabilize our financial system. I am deeply concerned and I assume that you will explain what those problems are.
Economic Advisor: Mr. President, let me preface this briefing by saying that we do not believe we are immediate danger of any upheaval in our capital markets. In a few days, the SEC and CFTC will release a joint report concerning a number of destabilizing events that have increasingly occurred in our financial markets over the past few years. All of these events have involved high speed trading using computers and how they are programmed to address imbalances between buy and sell orders. High frequency trading algorithms are designed to detect these imbalances automatically and protect traders from losses that might otherwise ensue. Essentially, the computers automatically revert to safe mode in a matter of seconds by retracting existing bid orders and closing out long positions. When the computers sense that the imbalance has cleared itself, normal high frequency algorithmic trading resumes.
President: So why is this a problem?
Treasury Secretary: Mr. President, high frequency trading accounts for over half of the volume on our exchanges. When these traders, or should I say their computers, detect a potential problem, they rapidly cease trading until the dust settles. It is the prudent thing to do, but when half of the volume dries up in a few minutes, the result is a scarcity of buyers for those who want to sell their shares. Prices drop and they drop precipitously. That’s what happened on May 6, 2010 and during numerous occasions afterward in trading of individual stocks. In other words, high frequency traders or, to be more precise, their computers get spooked and do what anyone else would do under similar circumstances. They protect themselves. Unfortunately, when they head for the exits, they leave many low-frequency investors holding the bag. Many of these slow-footed investors often lose large sums of money as a result. The problem is that these unfortunate events will continue to occur from time to time. It comes with the territory in a market dominated by high-frequency algo trading and it can happen at any time. The best we can do, in my view, which is shared by our market regulators, is to mitigate the impact on investors when such market disturbances occur.
Vice-President: This is a big fucking deal.
President: No kidding, Mr. Vice-President. You are an apostle of the obvious. Let me ask a question. How did a bunch of traders equipped with computers and software programs get to command most of the volume generated in the stock market? It looks like we have a situation where the tail is wagging the dog.
Economic Advisor: High frequency algorithmic trading has grown considerably since the Clinton Administration. With the advance of more powerful computers and the use of clever algorithms, it has taken off exponentially in the last five years. Frankly, the consensus opinion across a wide range of disciplines is that this is a positive development since it provides for more liquid markets. Everyone would benefit as the difference between bid and ask prices narrows. What we did not count on was high frequency traders immediately abandoning the market in unison when a trading imbalance occurs in the market. It’s a free market. We cannot force traders or investors to hold their positions, if they believe they will suffer losses.
President: Why not ban high frequency trading altogether so that it no longer controls most of the market?
Economic Advisor: With all due respect, Mr. President, I believe you just answered your own question. If we ban high frequency trading, a significant chuck of the market volume goes away along with the liquidity that it provides. The result would be a market collapse.
President: So let me understand this. If we stop high frequency trading, the market crashes because trading volume evaporates. If we allow it to continue, the market could crash temporarily from time to time when traders are spooked and exit the market en masse.
Economic Advisor: Mr. President, I believe you framed the problem quite succinctly. Please be advised that we believe these events, as embarrassing as they may be, do not occur very often. When they do occur, they can be mitigated through appropriate market control measures. That is why we needed to advise you of the nature of the problem so you are not blindsided.
President: I am very uncomfortable with this situation. First, we had big banks go nuts with mortgage-backed securities and had to bail them out. I am still taking heat from that. Now we have the same Wall Street crowd cornering the market with high frequency trading that could crash our financial system again at any time. First, they were too-big-to-fail; now they are too-big-to-ban.
Vice President: This is a big fucking deal.
Economic Advisor: The good news is that the SEC has taken firm measures to mitigate the problem. Circuit breakers will temporarily halt market activity if there is a large drop in prices within a pre-defined time interval. This would give the market time to clear any imbalances in an orderly manner. In most cases, the market self-corrects and normal trading resumes after a short interval of time. In fact, that is exactly what happened during the flash crash of May 6, 2010. We are also looking at other steps such as a limit up/limit down procedure that would curtail or prevent many anomalous trades outside a preset range from ever occurring. In short, the objective is to put brackets around the problem, thereby mitigating any adverse impacts on market participants.
President: I do not want any future problems laid at my doorstep because of inaction on my part. How can we prevent that from happening? What else can we do?
Treasury Secretary: The SEC has already suffered scathing criticism in the wake of the Madoff scandal. It is now being criticized about recurring market crashes. In addition to the measures that the Economic Advisor just mentioned, I recommend that we increase the SEC’s budget in order to bolster its regulatory and enforcement staff. We all understand that we cannot shut down high frequency trading. It is woven into the fabric our financial markets. The SEC’s new charge will be one of containment. In other words, the SEC can implement appropriate measures, as necessary, to alleviate any adverse impacts that may result from the dominant presence of high frequency trading in our capital markets. Certainly, no one can criticize you, Mr. President, if you have taken proactive steps to improve regulations and the enforcement capabilities of the Commission by increasing its budget. The onus will be on the SEC to keep our markets functioning properly.
President: That sounds like a reasonable approach. The last thing I need is a blip on my radar screen that could possibly turn into a massive market collapse. As the Vice President said, this is a big deal. Thank you, gentlemen. Please keep me advised.
As they walk out of the White House together, the Treasury Secretary whispers to the Economic Advisor that he is relieved the President never asked why high frequency trading has grown so rapidly. The Advisor nods in agreement. The link between high frequency trading, market manipulation and statistically impossible profits would be a very disagreeable subject indeed. Certain things are better left unsaid. A clueless president is easy to please.
It is another good day for Wall Street. It pays to have friends in high places who know the score. The wise guys always win.
Several Wall Street investment bank traders are munching on their lunch, which was hand-delivered from Delmonico’s directly to their desks. The topic of discussion du jour is an impending report from federal regulators concerning a series of market glitches purportedly caused by high frequency trading. Their mood is unsettled, even after having pulled down several million dollars earlier in the day through HFA trading. Here is part of their conversation.
Trader # 1: I can’t believe a mutual fund in bumfuck Kansas back in 2010 caused us to temporarily pull our bids and closeout our long positions. That meathead move brought unwanted scrutiny on our bread-and-butter business model. Instead of putting their computers to good use as we do, those assholes tried to hedge their long positions all at once and clogged up the entire system. Apparently, some fat-fingered pinhead made a similar mistake and caused the NASDAQ to shut down. Not only did that bring heat on us again, it prevented us from making surefire profits for three whole trading hours. Thank God, we incorporate multiple safety valves in our algos to automatically detect an imbalance so we don’t get waxed in a meltdown. The last thing we need is pain-in-the-ass government bureaucrats thinking they have to do something to placate the public, when we know and they know, they can’t do anything to stop us. HFA trading is here to stay. They can’t un-ring the bell without bringing down the whole fucking financial system.
Trader # 2: Yeah, we also have those pointy-headed quants giving us fits as they try to wring out a few bucks using their probabilistic models. They churn out massive volume just to cherry-pick a perceived mathematical disparity in the market. Fuck that rocket science crap. With so many damn computers and algorithms doing their own thing, traffic is getting congested out there. It’s too easy to trip over each other and cause a crash, albeit a temporary one in most cases. Don’t get me wrong. I’m not saying I want a traffic cop looking over our shoulder. I just want these rookies to get the hell out of our way.
Trader # 3: These yo-yos don’t understand that the expressway to easy profits on a day-in, day-out basis is old-fashioned pump-and-dump algorithms. I love the word ‘algorithm’. Eyes glaze over immediately when people hear that word. It’s like swinging a watch in front of their faces. They should only know that algorithms are nothing more than simple software routines that any high-school dropout with half-a-brain can easily put together. Fortunately, our firm wants lettered guys like us with advanced business degrees and computer skills to run their proprietary trading desk. It gives the appearance that we are savvy street traders, who have an uncanny ability to accurately discern the prospects of the companies we trade. Our real skill, however, is knowing how to juke investors out of a few pennies in high volume 24/7. We are rainmakers. Our cheerleaders over at CNBC think we are geniuses. Our bosses love us and our benefactors in the federal government love us. After all, we provide a valuable service to humanity. We keep the market from crashing and protect American investments in the process. Therefore, we deserve the right to exact a small tax on investors. Our friends over at the Fed and the Treasury understand this and will pull out all stops to protect us. It’s a win-win situation. They use us as an invaluable tool to implement economic policy and we get to bag big-time profits every single trading day. Some call it market manipulation, but that is nothing but a jealous slur on our professional integrity. I prefer to call it nuanced trading. Although, I have to admit flash trading is a little over-the-top. We get to look at another player’s hand before we make our move. God bless the SEC though. They have been studying this for years and still haven’t banned what is blatant cheating by any definition. It’s self-evident. That’s how in the tank they are. Even if they weren’t in the tank, those idiots couldn’t find their ass with both hands and a flashlight.
Trader # 1: Getting back to the increase in market mishaps for a second, I am worried that this whole thing can come crashing down around our ears. Next time, the market might plummet and stay down through no fault of our own. Our computers are programmed to react instantaneously if a dislocation is detected in the market. In some cases, we have no idea what is causing the imbalance between buy and sell orders. The safest thing to do is step out of the way until the dust settles. The problem is our competitors are doing the same exact thing at the same exact time. Liquidity dissolves in a matter of seconds and causes the bottom to drop out of the market. It’s that simple, but it’s not our fault.
Trader # 2: Although we have a nice thing going, we can’t afford another major crash, even a temporary one, because the public, and certainly the media, will blame us. They are already asking hard questions. The outcry will make our lives miserable, even with the government running interference for us. If push comes to shove, the politicians will hang us out to dry. The argument that HFA trading provides needed market liquidity, which narrows the spread between bid and ask prices, is wearing thin. The truth is most of our nuanced strategies would be totally useless without high volume, high frequency trading. Our profits would dry up in a New York second. The suits in our front office are excellent at deflecting criticism but the tenor of public opinion is decidedly against us. We’re already in the doghouse.
Trader # 3: Listen, this conversation is giving me indigestion. We are safe. There is no way the regulators are going to admit they allowed nuanced HFA trading to go on for years and then suddenly discover it is illegal. The public would be outraged and take to the streets with pitchforks in hand, especially after that Madoff fiasco. If they haven’t banned flash trading, why does anyone think the SEC is going to ban our more sophisticated pump-and-dump, front-running trading strategies? No fucking way. Besides, HFA trading is well over half of the market exchange volume. If it dries up, the market crashes. That’s just what the government does not want. That’s also why our friends at the Federal Reserve keep QEternity going. We use easy money from the Fed to fuel the stock market. We collaborate with the Fed to provide market plunge protection. We have earned the right to wet our beaks. In short, we have the government by the short hairs. Besides, we kick over a nice piece of our profits to fund politicians of both parties. We are golden. We are untouchable. We are too-fucking-big-to-fail. Now, please excuse me while I wolf down this steak sandwich.
That is why the wise guys always win.