Flash Crash Cash

The spin has already started on the flash crash that sent yesterday's market down 1000 points (largest one-day drop ever) and most of the way back up in the space of less than half an hour. After a lot of speculation, the trigger now stands identified as NYSE's brief (under two minutes) mechanical pause in trading for five stocks whose buyers and sellers had drifted too far apart. (I suspect there is more we don't know yet).

How did such a small action cause such fallout? The answer comes from computerized trading where algorithms tell computers when and how to execute trades. There are so many of these that we saw extreme results: some stocks trading at zero (which is a computer finding no buy orders and therefore bidding a penny) and a stock that started and ended the day around $34 a share but in between hit $100,000 a share (Sotheby's).

What was it about the NYSE pause that set this in motion? The answer is liquidity, much like the credit crunch that hit a few years ago. When the NYSE used to control most of the stock of the companies on its exchange, it could pause trading without incident. Today, the NYSE controls only about 25% of the stock of the companies on its exchange. The rest is controlled by private, mostly computerized companies like Tradebot (yes, that is its real name).

When the NYSE shut off its trading momentarily, other traders registered the event as a sudden loss of liquidity--as if trading volume had suddenly left the market. This triggered a computerized panic followed by a human panic long after the triggering event was over. And even more reassuring, nobody's quite sure why the market rebounded so fast; it's suspicious. (How computerized trading is rigged.)

Among many automatic actions that were triggered, firms like Tradebot suspended trading at -500 points. At first glance, this sounds like a bad thing. Dick Rosenblatt, chief executive of Rosenblatt Securities (whose site features a Dark Pool Liquidity Tracker right on the home page), was quoted in The Wall Street Journal saying that the triggers were bad because by halting trading, the tradebots of the market withdrew more liquidity and thus accelerated the fall. He said,

"How have we incented algorithmic traders and high-frequency traders to enter our markets in times of stress? We really haven't."

In other words, he suggests that there are traders out there who would enter the market in times of stress to add liquidity if only there were financial incentives for doing so. We could avoid future flash crashes by rewarding these white knights who add liquidity to the market.

How would they add liquidity to the market? By buying up falling stocks at below-market prices. And....they need extra incentive for this?

Yes. As it turns out, exchanges like NASDAQ are backing out the most extreme of the transactions that occurred during the flash crash, 2/3 of which involved ETFs. Only transactions that were within a certain percentage of the pre-trigger price were allowed to stand--and that could hang speculators--excuse me, white knights adding liquidity to the market--out to dry.

For example, suppose a stock began the day at $60. A trader bought the stock at $10 then sold on the rebound at $50. The buy is wiped out because the price is too extreme. But the sale is within acceptable price range and would stay. Thus, the trader is left holding the shares short at $50. His previous profit is wiped out. To make a profit now, he must buy again at a price far enough below $50 to cover trading costs—and this on a stock that started the day at $60.

I want to point out here that the esteemed Wall Street Journal only interviewed HFT (High Frequency Trading, aka speculating, day trading, and churning) insiders for its article. The other quoted source was from a company that creates computerized trading programs. What were they going to say, that algorithms are a mixed blessing, allowing greater efficiency in trading and portfolio design while also creating potential market energy that can be manipulated by speculators?

Not hardly.

Did the esteemed Wall Street Journal talk to anyone not profiting from HFT? Public official? Long-term investor? Investment science academic?

Not hardly.

So what we have here is a WSJ article whose only quoted sources represent the speculators that are still, even now, siphoning short-term profits out of the economy. The article presents only the idea that speculators, who are quite able to CAUSE crashes, should be let loose to fully profit from crashes.

Fortune starts off with good skepticism, zeroing in on the trigger as the key question, but then says,

What, if anything perpetuated the selloff? And did so in seconds? There's a lot of speculation about high-frequency traders vanishing from the marketplace. The consensus is that high-frequency guys didn't provide the liquidity and that's what allowed for prices like one penny on Accenture.

In point of fact, this is accurate: HFTs withdrew liquidity. But the implication here is that HFTs should have provided liquidity--should have bought in at below-market prices to save the market.

Why in the world settle on HFT? Why not government? Why not shut the whole market down if things go nuts?

I don't favor a particular solution to this problem, but I do have a problem when only one solution is considered and that "solution" perpetuates bad financial management.

On the other hand, I do own a soapbox called "putting limits on speculation as a percentage of total market volume to prevent bubbles and steer more money toward true economic growth." Congress and economists have not embraced this idea the way I'd like, but I still hope that regulating derivatives is a first step toward limiting gambling and HFT.

Toward that end, I can just picture future Congressional testimony that we can't possibly limit HFT because we need their liquidity to stabilize the market in the event of a crash.

We must always remember this is us vs. them. Speculators profit from market volatility--and know how to cause it. Long-term investors and our national economy prosper from stable market growth.

Now the speculators say that only they can save us from market instability, but we both know what they are asking for is protection money--and the financial press is willing to be their mouthpiece.