The SEC and CTFC have pinpointed the trades that began the flash crash on May 6th and issued a report. Instead of calming the fears of investors, the report should increase their anxiety, assuming they are paying attention. A single mutual fund, who tried to hedge its positions in a relatively short time interval, caused high frequency algorithmic (HFA) traders to pull their bids and crash the stock market temporarily before prices rebounded a few minutes later. The report indicates that the timing of the mutual fund’s trades in the midst of a nervous trading day, due to concerns over the state of European financial system, was a big catalyst in spooking HFA traders to pull their bids or sell into the quickly falling market thereby exacerbating the short-lived downward spike in market prices.
The report fails to emphasize that this inherent fragility is due to the fact HFA traders control over 70% of the volume on stock market exchanges. Effectively, HFA traders have a corner on the market. That, in itself, should be cause for deep concern since they can control market movements in either direction. It is never a good idea to tolerate those who try to corner and control what are supposed to be fair and open capital markets. While the report acknowledges that HFA-generated volume does not translate into liquidity, it does not flag this as a major problem, which can trigger a stampede to the proverbial narrow door anytime HFA traders and investors try to exit the market due to some event or series of events. The report states that HFA traders have computer programs that can quickly detect when there is a dislocation in market activity and can react instantaneously. In most cases, the algorithms simply go to standby mode until the dust settles, as was the case during the flash crash. There is an instantaneous imbalance of buy and sell orders, with buy orders conspicuous by their absence. When 70% of the buy-side volume dries up, investors are left holding the bag. Perversely, even those who were prudent enough to place stop loss orders to protect themselves were stopped out at much lower prices than they had specified.
One can argue that the SEC is either incompetent or complicit, but the result is the same. The market is vulnerable to the machinations of HFA traders who could care less about retail investors. Perhaps, government regulators are in a Catch-22 situation. If they rein in high frequency computerized trading, the market may crash because there will be no one to prop up the market artificially with wave trading. See investmentwatchblog.com/the-wave/. If the SEC leaves conditions as they are, the market will remain vulnerable to frightening downdrafts anytime HFA traders are spooked by some event. The next flash crash may not be a flash.
By the way, the proposed band-aids, like imposing circuit breakers, are palliative measures at best because they are rather ineffectual and could actually make matters worse. The stampede to the narrow door could grow during the timeout making the squeeze and panic more palpable and lethal. In 20/20 hindsight, the SEC should have never allowed this HFA Frankenstein to proliferate to the point where it controls the lion share of market volume. It is just a matter of time before we walk through the debris field left in the wake of destruction wrought by unbridled HFA trading. It did not have to be this way. The wise guys always win.