A Market Crash Waiting To Happen

by LV

It has been almost four years since the infamous flash crash that occurred on May 6, 2010.   There have been numerous mini-flash crashes in individual stocks since then. It has been about one and a half years since Knight Capital imploded when one of their high frequency algorithms went rogue and caused them to lose $460 million in a matter of minutes.

The SEC has done nothing of substance to prevent a replay of those unnerving market events because it has done nothing to address the root of the problem.  Instead, the growth in high frequency algorithmic (HFA) trading has gone unchecked as more and more firms seek ways to shave a few milliseconds or microseconds off the time it takes to receive data from market exchanges and execute a trade.  A tiny sliver of a second is all that’s needed to gain an unfair advantage over unsuspecting investors. The quest for a HFA trading edge has firms paying exchanges large sums of money to receive special access to trading data a few milliseconds ahead of the general public.  Companies co-locate their servers as close to the exchanges as possible so data, traveling near the speed of light, finds its way home to their computers and into their algos as rapidly as possible. Companies opt for microwave transmissions or lasers to supplant light waves traveling through fiber-optic cables because those pathways are incrementally faster.  It’s a race to riches.

Speed and greed go hand in hand in the world of high frequency traders, who routinely front-run and juke investors and retail traders out of pennies and nickels in huge volume every single trading day.  The proprietary trading desks at big Wall Street banks routinely score tens of millions of dollars almost every trading day through HFA trading. They report unbelievable consecutive daily profitable trading gains quarter after quarter, which are statistically impossible unless they are cheating.  Yet, the SEC sees nothing untoward with these kinds of results. See a previous InvestmentWatch article on this subject: investmentwatchblog.com/u-s-officials-and-wall-street-traders-react-to-continuing-hfa-glitches/

The problem, of course, is that HFA trading comprises well over half of total market volume.  High frequency trading proponents argue that such trading provides needed liquidity to the market and everyone benefits as the difference between bid and ask prices narrow.  In fact, the ones who benefit the most are high frequency traders themselves who need high volume for their manipulative algos to work effectively and churn out obscene profits.  Why else would HFA traders go to such pains to acquire trading data a few milliseconds ahead of other market participants? The perverse beauty of the practice, in the eyes of HFA traders, is that most investors don’t notice the difference.  Investors aren’t aware that they are paying a few pennies more than they should have to complete a transaction.

HFA trading has nothing to do with green eyeshade analysts who try determine the prospects of various companies and advise their clients accordingly.  It has everything thing to do with removing almost all risk by dramatically increasing the speed of data flowing between HFA computers and the market exchanges.  Technical and fundamental market analyses are old-school in such an environment. Why take any chances when surefire profits are available for the taking each and every trading day through the wonders of high speed trading?  While the SEC dithers, HFA traders and their programmed computers are hauling in boatloads of dough in a risk-free, essentially unregulated environment. It doesn’t get much better than that.

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HFA traders are astute enough to know the soft underbelly of their enterprise.  The wise guys know better than to get caught flat-footed and, therefore, take preemptive measures to bail out at the first sign of an incipient market collapse.  That is why they design safety release valves into their algorithms, which will automatically sell out their long positions and pull back their bids in a matter of seconds as soon as an unusually large imbalance appears between buy and sell orders.  In effect, HFA computers are programmed to sell first and ask questions later. This collective computerized response on the part of HFA traders creates a vacuum under stock prices sending them into freefall.

HFA traders appear to have all their bases covered.  They profit from gathering trading data milliseconds before other market participants.  They cut their losses well before other market participants have a chance to react. It’s a win-win for HFA traders and a lose-lose for everyone else.  

The SEC is fully aware of how a market or an individual stock reacts when liquidity dries up suddenly.  It goes down and it goes down abruptly. After the flash crash of 2010, the SEC instituted a few changes that they believe would mitigate a devastating crash when HFA traders leave the market en masse in a matter of seconds.  To address these types of market perturbations, the SEC decided it would suspend trading temporarily for a prescribed period of time to give the market or an individual stock a chance to recover from what could be a momentary trading imbalance.  In fact, that is exactly what happened during the flash crash. The Dow dropped several hundred points in a matter of minutes and just as quickly recovered most of its losses within an hour.

Temporarily suspending trading, however, is a questionable patch, which may or may not stop a market collapse.  In fact, the so-called circuit breakers could exacerbate a market fall as easily as they could halt it. When market trading is suspended after a circuit breaker trips, uneasy investors could pile up anxiously waiting to unload their shares when the circuit breaker resets and trading resumes.  A simple waterfall could turn into a cascading waterfall that is deeper and longer as panic sets in.

The thing that distinguishes this market environment from those in the past is the dominance of HFA trading.  Who can say what will trigger another flash crash or when it will occur? Further, we don’t know if the next crash will be another flash in the pan or the nerve-shattering start of a long bear market.  The current bull market is long in tooth and the percentage of bears is near a record low level. But this doesn’t necessarily mean that a reversal is imminent, especially with a Fed that will do almost anything to keep the market from plunging.  What is more predictable is the likelihood that the next market crash could be a steep scary one, like none ever seen before. This is what happens when a stock market is underpinned by the fragile liquidity of high frequency trading. It is no different than a house built on sand, which is destined to collapse under its own weight.  

So what can be done to forestall or prevent such a scenario?  Unfortunately, not much at this point. Our market regulators should have never allowed HFA trading to grow to the extent it has.  HFA trading has attained critical mass and government regulators are not about to burst the bubble. They have signaled that the most they will do is try to contain the problem rather than cure it.  Not only do they fear the political backlash that would accompany any move to ban or seriously curb HFA trading, they are even more fearful that any action on their part to eliminate or reduce a major fraction of market volume will in itself cause the market to collapse.  The SEC may believe, at this point, that they are damned if they do and damned if they don’t.

The SEC has been studying the issue for years, but has yet to do anything meaningful to eliminate the potential threat posed by HFA trading on the health and wealth of the general market and honest investors.  They will put band-aids on the problem, but they refuse to attack the problem at its root. Other than sporadic market anomalies, it is fortuitous that the market hasn’t experienced any long-lasting setbacks due to HFA trading.  That luck may not last much longer, nor will the bull market that is camouflaging the danger.

Unfortunately, it may take a market crash before any meaningful action is taken to address the self-evident systemic risk associated with HFA trading.  Complaisant investors, who place their trust in our market regulators to provide a level playing field, can see their paper gains evaporate and fresh losses appear in a matter of moments.  It is a matter of time before an unsettling market collapse occurs, aggravated by HFA trading. When it does, burnt investors will be leery, perhaps for a very long time, to trust our financial markets.  Perhaps then, and only then, will market regulators take meaningful steps to protect investors from predatory high frequency traders. In the aftermath of a brutal market collapse, the American public will demand that the integrity of the marketplace be restored.  

No privileged, well-connected class of traders should have the ability to see the bid and ask prices of other market participants before making their move.  It is otherwise known as cheating and anyone paying attention knows it. To make matters worse, HFA trading has woven itself into the fabric of the market to such an extent that its flight at the onset of a market dislocation will quickly make a bad situation worse, leaving investors holding the bag and wondering why our market watchdogs didn’t see this coming.