Flash Crash Information and Regulatory challenges
E-Mini Narrative (CDT) • It was stormy morning, stocks down • 13:32 Large seller hedging equity position in the e-mini with a sell program looking for 9% volume participation • 13:42 high frequency traders buy and then sell and then sell and sell in the cash market • 13:45 “hot potato” passed around increasing volume and program sells • 13:45:28 5 second pause in e-mini • 13:45:33-13:45:58 prices stabilize • 13:46 fundamental buyers back in • 14:08 price up to 13:32 level
Stock Narrative (EDT) • Though e-mini crash stopped by 2:45 sell orders to individual SP500 equities and ETF’s continued to cash market which had been slowed down by very high message traffic • “Market Makers” backed away from cash markets leading to trades at “stub quotes” • By 3:00, most stocks close to their 2:00 levels • Between 2:40 and 3:00 20,000 trades at prices 60% away from their 2:40 level • Finra and the exchanges agreed to break such trades
HFTs • High frequency traders do not necessarily trade so fast, but they do quote fast, with quotes responding to new information (or ?) • They are, in part, unofficial market makers providing quotes (liquidity) to those who wish to trade
Economics of Market Making • Market makers make money by buying at the bid and selling at the higher offer • Costs of market making • Opportunity costs • “risk” costs-cost of inventory value fluctuating • Providing quotes to traders with superior information
Information and Market Making • On average, a market maker loses money when selling to an informed buyer and buying from an informed seller • After an informed buy the level of the quotes will change so that buying at the bid and selling at the offer need not lead to a profit • Wider spread must be maintained to compensate for losses to informed traders
Information • The width of the spread between bid and offer is a function of how much difference in information there is between informed traders and those making a market • HFTs maximize the amount of information they have by processing information on many different securities • Ability to respond to information (low latency) means they can quote tighter spreads
Order flow information • The information can be directional but can also give an indication of whether there is a lot of potentially informed trade • Indication of aggressive selling signals both a direction and the possible presence of informed trade • Drop bid price • Widen spread
Market Breakdown • If market makers have reduced information and/or indication of very aggressive trading the optimal action may be to stop quoting • Or use stub quotes of bid $.01, $100,000 offered
Back to 5/6/10 • An apparently very large sell program starts in the E-Mini • 9% of previous minutes volume • Natural escalation but not a big deal • No limit price attached (unpriced) • Who could have private information about the entire economy? but Who would be crazy enough to send in such orders if they did not have information?
CME market makers • CME market makers build up positive inventory which they seek to hedge, fast and aggressively in the cash markets • SPY, other ETF’s and individual stocks • Seek to unload e-mini futures to others who also try to unload as price drops • Increase in volume increases the aggression of the original sell order making market participants more nervous
Listed stocks • Market makers in listed stocks (NASDAQ and NYSE) trade on Archipelago, BATS, KNIGHT, etc • Algos see very aggressive sell orders and attempt to respond to information • Flood of orders, order changes and cancellations clog up the system, particularly at NYSE
Lack of Information • Trades are reported through one system (CTS) while quotes are reported through another (CQS) • Massive number of quotes and cancellations means quote information delayed relative to trade information • See trades without corresponding quotes • What is going on?
Shut it Down • Many HFTs decide not to play and wait and see • CME calms down but takes longer for information to be processed in the equity markets as quotes are delayed • Which finally calm down as well
CME v NYSE • According to CFTC, HFTs not responsible • They did what they have always done • Both make and take liquidity • Appears to have been withdrawal from equity markets • So story seems to be different • Why?
Is my story true • Not inconsistent with joint CFTC/SEC report • What we really need is more data • SEC agrees and actually proposed this before the flash crash
SEC information proposals • Rule 13h-1 under the authority of 13(h) of the Exchange (34) Act • Requires large traders (2mm shares or $20mm in a day or 10x that in a month) to be registered with unique identifier assigned by SEC • Broker/Dealers must keep record of ID and time stamp of all executions by a large trader • Broker/dealers report large trader information through the Electronic Blue Sheets upon request • This will allow SEC to • Assess impact of larger trader activity • Reconstruct trading activity following unusual volatility • Analyze significant market events • Do they have the capacity to analyze the data?
Changes to Rule NMS • Rule 613 (proposed, not adopted) of Reg NMS would require exchanges to construct repository for data on all trades and quotes by client (not just clearing broker) • Not just trades but quotes • How will SEC process data?
Reason for rule change • Clearing is handled, for most transactions, at the broker level • Only info reported to FINRA is representing brokers, not clients • Only info on quotes is “top of the book” • Best bid and offer and size at best bid and offer • SEC can get client information, but requires request and response by broker
A lesson • If you are trading equities, always use limit orders with reasonable limit prices • You may not trade right away, but it can prevent very disadvantageous trades that will not be broken
Speculation • One company, Nanex (nanex.com), thinks there was and is something more sinister going on • flood of message traffic disrupts market • For example quote and quote cancellations at very high volume lead to other machines getting out of the market leaving a wide bid ask spread and source of quotes buys at low bid and sells at high offer