Market or Casino?

High Frequency Trading is something we continue to watch and about which we remain concerned. Here is an interesting article in the New York Times about the continued growth of HFT exchanges.

New York Times

This article from the Atlantic was written over the summer. It does a good job showing, graphically, the algorithms at work.

The Atlantic

Finally, this is some internal research we did this fall on the little talked about “Flash Smashes”

Flash Smash
On a number of occasions over the months since the now infamous “Flash Crash, ” we have commented on the dangerous interaction between high frequency trading and Exchange Traded Funds. We have also monitored (and commented upon) attempts by politicians and regulators to reign in the potential negative impact of the robot traders.
One such attempt was the installation of the “Circuit Breakers” designed to halt trading in a stock whose price changes more than 10% in any five-minute period. These breakers were installed in June 2010.
Since then, there have been a number of HFT-induced mini-flash crashes that have tested the usefulness of the circuit breakers. One instance we identified occurred on September 27, when Progress Energy Corp (PGN) fell from $42 to $4.57 in three minutes (See graphic below). How did this happen when the parameters of the circuit breakers were clearly violated? More than 100 trades occurred after the stock triggered the halt, resulting in nearly 60 trades being cancelled. It would appear that the HFT’s have the ability (at least for a short period of time) to outrun the circuit breakers. The “offending” trades were cancelled.

Extremely large and fast orders placed on illiquid exchanges by HFT’s (known as “ripping the book”) caused another mini-flash crash in Nucor Corp on September 14. In 1/100th of a second (at 8:52:21) Nucor’s price fell from $39.58 to $0.01. Trading was then halted for 5 minutes and the stock re-opened at $ 39.90. The orders that toppled the price were cancelled. See graphic below.

One final example of this structural flaw can be found in the stock of LiveDeal (LIVE). LiveDeal closed at $4.42 on October 20. It traded roughly around that price until 12:11:58 when, inexplicably, the price spiked to $22.25 in a matter of minutes. No circuit breakers kicked in despite the outsized gain (note that the circuit breaker language says “price changes” by more than 10%, not “price falls”), and none of the offending trades were cancelled. If one were apt to believe in conspiracies, one might conclude that HFT’s are prohibited from taking out the bottom of a stock’s price, but they are freely permitted to lift a stock’s price as highly and as quickly as they wish.

We began following this phenomenon in earnest after reading an article titled “It’s Not A Market, It’s An HFT ‘Crop Circle’ Crime Scene” back on July 31. That article referenced research by Nanex, a market trading analytics firm, which had been extensively analyzing the flash crash tick-by-tick. On October 14 they released their conclusion on the causes of the May 6 Flash Crash. The conclusion can be found at:

Nanex.net

While the conclusion makes sense, the regulatory response seems at least partially inadequate against the backdrop of the trades we’ve illustrated above. The risk is one that we continue to carefully watch – both in terms of regulatory developments and real-time hedging strategies.

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