On May 6th, the Dow Jones Industrial Average dropped almost 1000 points in a matter of minutes and just as quickly recovered most of the losses. This unprecedented event set in motion a series of conversations among public officials and traders. All of the conversations shared the elemental human reaction of high anxiety. The angst resulted from the uncomfortable realization that the problem exposed for all to see during the so-called flash crash cannot be swept under the rug. Was the tremor felt during the flash crash a one-off event or was it the first warning sign of an earthquake to come that will rock the financial world? There is a big difference between a natural disaster and a man-made disaster. A man-made disaster is avoidable and can be corrected in most cases once the problem is identified. The question is whether man has the courage and wherewithal to take corrective action. Since May 6th, there have been no similar market-wide dislocations in trading activity, but there have been a disturbing number of mini-flash crashes in individual stocks. See www.nytimes.com/2010/11/09/business/09flash.html?_r=1&scp=2&sq=graham%20bowley&st=cse. These fissures in trading activity indicate latent brittleness and instability in the market infrastructure. The root of the problem remains. The implications for our capital markets are a real and present danger. Next time, the market crash may not be a temporary phenomenon.
The regulators, the president and the traders discuss the flash crash. Let’s listen in.
In the wake of the May 6th flash crash, senior managers gathered in the war room at the Securities and Exchange Commission. The mood was tense. A few days earlier, the Dow dropped almost a thousand points in a few minutes and scared the pants off the financial world. The SEC was completely blindsided. The media were demanding answers and wanted them yesterday. In the room was a broad spectrum of disciplines and backgrounds including a securities law specialist (lawyer), an ex-Wall Street executive (wise guy), an ambitious by-the-book regulator (enforcer), and a political operative from the White House (politician). Here are snippets of their conversation.
Politician: “Needless to say, the White House has been inundated with angry phone calls and emails wanting to know what caused the flash crash. The Press Secretary is doing his level best trying to deflect questions from the media but he cannot hold them off forever. Our fragile economic recovery cannot withstand such perturbations. We need answers and we need them quickly. What the hell happened?”
Lawyer: “The SEC has convened a board of inquiry to investigate the matter. We have early indications that a large sell order from a firm in Kansas caused a trading imbalance, which precipitated a temporary dislocation in market activity.”
Enforcer: “We know much more than that. Our people have known for years that the unbridled growth of unregulated high frequency algorithmic (HFA) trading has created conditions that were ripe for the type of crash that occurred on May 6th. It was an accident waiting to happen and still is. We believe that traders are using HFA trading and computers to game the market each and every day through market manipulation. One just has to look the consecutive string of statistically impossible, profitable trading days to know they are bilking investors. Yet we are told to stand down. High frequency trading is off-limits. For chrissake, we still haven’t banned flash trading, which is the very definition of cheating. It’s almost like HFA trading is too-big-to-bust.”
Wise Guy: “Listen, these unfounded accusations simply feed into a frenzied paranoia among investors, which itself unsettles the market. High frequency trading provides needed liquidity to our capital markets by narrowing the spread between bid and ask prices. Everyone benefits.”
Enforcer: “Yeah, everyone on Wall Street. Any perceived narrowing between bid and ask prices is gobbled up by HFA traders who manipulate prices higher. Investors pay more for their shares and the HFA traders bag the difference. It is tantamount to an undeclared tax on each transaction. The so-called liquidity that HFA trading creates is ephemeral and will flee the market in a heartbeat just as it did a few days ago when a trading imbalance was detected. When that happens, the market crashes. It can happen at any time and next time it may not be a temporary phenomenon. With control of 70% of the volume, HFA traders have effectively cornered the market.”
Wise Guy: “That is sheer alarmist rhetoric and has no place in this discussion. HFA trading has been going on for years and now you are suggesting that we shut it down. We will be run right out of town for gross incompetence.”
Politician: “Gentlemen, can we stay on topic? First, we need a thorough examination of what occurred during the flash crash event and why it happened. Second, the White House is deeply concerned that this might happen again. If so, it wants to be prepared.”
Lawyer: “That is exactly why we have enlisted the services of Wall Street experts to assist us in our investigation. After all, who is better equipped to explain the intricacies of high frequency trading and how it reacts under such conditions?”
Wise Guy: “Excellent move.”
Enforcer: “So let me understand this. We are going to have the fox help us investigate the break into the hen house? The SEC is perfectly capable of tracking trade and tape information to determine exactly what occurred and why it occurred. It would be easy for us to prove that these firms are using algorithms to manipulate the markets to their advantage. We can also determine exactly how this type of activity makes our capital markets vulnerable to a crash during a dislocation. The integrity of the marketplace is at stake. If we have to, we can shut down HFA trading before it too late.”
Wise Guy: “That kind of talk is insane and irresponsible. It sounds like you have made up your mind without one shred of evidence of any wrongdoing.”
Politician: “O.K. Let’s get to bottom of the flash crash first. It is perfectly reasonable to have Wall Street experts assist in the investigation because they can offer resources and expertise that we lack, especially as it relates to such complicated trading activities. When can we expect a draft report on this matter?”
Lawyer: “It will take a few months. In the interim, the SEC has decided that the installation of pilot circuit breakers on our exchanges should be sufficient to mitigate and limit any exposure to another flash crash, if one should recur. After our report is delivered, we will convene a committee to look into HFA trading activities in more depth to determine whether any further action is necessary.”
Enforcer: “I do not detect any sense of urgency. Am I correct?”
Politician: “This meeting is adjourned. In the meantime, it is business as usual. Frontline regulators shall take no further action on this issue until we receive the final report and review its recommendations.”
Such is life at the SEC. The delicate matter is left in the capable hands of a politician, a lawyer, and a wise guy, all of whom represent the interests of Wall Street. The enforcer is told to back down because he is not a team player. He does not understand that the wise guys always win.
Shortly before the joint report of the SEC/CFTC was released to the public on September 30th, a meeting was held in the Oval Office of the White House. In attendance were the President, the Vice-President, the Secretary of the U.S. Treasury, and the Chief Economic Advisor. The President had been advised that the issue at hand was of grave national importance and concerned certain conditions in our capital markets that could potentially lead to the instability of our financial system. Here is their conversation.
President: “Gentlemen, I understand that there are latent problems within our marketplace which could de-stabilize our financial system. I am deeply concerned and I assume that you will explain what those problems are.”
Economic Advisor: “Mr. President, let me preface this briefing by saying that we do not believe we are immediate danger of any upheaval in our capital markets. Tomorrow, the SEC and CFTC will release a joint report on the flash crash that occurred on May 6th. That afternoon, the Dow Jones Industrial Average tumbled almost 1000 points in a matter of minutes and just as quickly recovered most of the losses. The ensuing investigation revealed that a mutual fund firm in Kansas effectively jammed the market with a very large sell order as it tried to hedge its long positions. This action caused a ripple effect in an otherwise jittery market and caused many investment banks and large hedge funds to retract their bid orders and closeout their long positions. High frequency programmed computers carried out the entire sequence of events, which led to the flash crash. In other words, the computers automatically sensed an imbalance of buy and sell orders in the market and, within a matter of seconds, took evasive action to protect traders from losses until the imbalance cleared itself.”
President: “So why is this a problem?”
Treasury Secretary: “Mr. President, high frequency trading accounts for approximately 70% of the volume on our exchanges. When these traders, or should I say their computers, detect a potential problem, they effectively cease trading until the dust settles. It is the prudent thing to do, but when 70% of the market volume dries up in a few minutes, the result is a scarcity of buyers for those who want to sell their shares. Prices drop and they drop precipitously. That’s what happened on May 6th. In other words, high frequency traders were spooked and did what anyone else would do in a similar situation. They protected themselves and left investors holding the bag. Many investors lost huge sums of money as a result. The problem is that this can happen again and it can happen at any time.”
Vice-President: “This is a big fucking deal.”
President: “No kidding, Mr. Vice-President. You are an apostle of the obvious. Let me ask a question. How did a bunch of traders equipped with computers and software programs get to command a 70% share of the volume generated in the stock market? It looks like we have a situation where the tail is wagging the dog.”
Economic Advisor: “High frequency algorithmic trading has grown considerably since the Clinton Administration. With the advance of more powerful computers and servers along with clever algorithms, it has taken off exponentially in the last five years. Frankly, the consensus opinion across a wide range of disciplines agreed that this was a good development since it provides for more liquid markets. Everyone would benefit as the difference between bid and ask prices narrows. What we did not count on was high frequency traders immediately abandoning the market in unison when a dislocation or perturbation occurs in the market. It’s a free market and we cannot force traders or investors to hold their positions, if they believe they will suffer losses.”
President: “Why not ban high frequency trading altogether so that it no longer controls 70% of market volume.”
Economic Advisor: “With all due respect, I believe you just answered your own question. If we ban high frequency trading, 70% of the market volume goes away along with the liquidity that it provides. The result would be a market collapse.”
President: “So let me understand this. If we stop high frequency trading, the market crashes. If allow it to continue, the market could crash at any time, if traders are spooked and exit the market.”
Economic Advisor: “Mr. President, I believe you framed the problem quite succinctly.
Please be advised that we believe there is a very low probability of such an event happening again anytime soon. But then again there is always a small chance that it could. That is why we needed to advise you of that small probability so you are not blindsided.”
President: “I am very uncomfortable with this situation. First, we had big banks go nuts with mortgage-backed securities and had to bail them out. I am still taking heat from that. Now we have the same Wall Street crowd cornering the market with high frequency trading that could crash our financial system again at any time. First, they were too-big-to-fail; now they are too-big-to-ban.”
Vice President: “This is a big fucking deal.”
Economic Advisor: “The good news is that the SEC has taken firm measures to mitigate the problem should it arise again. Circuit breakers will temporarily halt market activity if there is a large drop in prices within a pre-defined time interval. This would give the market time to clear any imbalances in an orderly manner. We are also looking at other steps such as a limit up/limit down procedure that would curtail or prevent many anomalous trades from ever occurring.”
President: “I do not want any future problems laid at my doorstep because of inaction on my part. How can we prevent that from happening? What else can we do?”
Treasury Secretary: “The SEC has already suffered scathing criticism in the wake of the Madoff scandal. It is now being criticized about the flash crash. In addition to the measures that the Economic Advisor just mentioned, I recommend that we increase the SEC’s budget in order to bolster its regulatory and enforcement staff. We all understand that we cannot shut down high frequency trading. The SEC’s new charge will be one of containment. In other words, the SEC can implement appropriate measures, as necessary, to alleviate any adverse impacts that may result from the dominant presence of high frequency trading in our capital markets. Certainly, no one can criticize you, Mr. President, if you have taken proactive steps to improve regulations and the enforcement capabilities of the Commission. The onus will be on the SEC to keep our markets functioning properly.”
President: “That sounds like a reasonable approach. The last thing I need is a blip on my radar screen that could possibly turn into a massive market collapse. Like the Vice President said, this is a big deal. Thank you, gentlemen. Please keep me advised.”
As they walked out of the White House together, the Treasury Secretary whispered to the Economic Advisor that he was relieved the President never asked why high frequency trading was growing so rapidly. The Advisor nodded in agreement. The link between high frequency trading and market manipulation would be a very disagreeable subject. Certain things are better left unsaid. A clueless president is easy to please.
It was another good day for Wall Street. It pays to have friends in high places who know the score. The wise guys always win.
Several Wall Street investment bank traders munched on their lunch, which was hand-delivered from Delmonico’s directly to their desks. The topic of discussion du jour was the SEC/CFTC’s report concerning the May 6th flash crash. Their mood was unsettled, even after pulling down several million dollars earlier in the day through high frequency algorithmic (HFA) trading. Here is part of their conversation.
Trader # 1: “I can’t believe a mutual fund in bumfuck Kansas caused us to temporarily pull our bids and closeout our long positions. Instead of putting their computers to good use as we do, these assholes tried to hedge their long positions all at once and clogged up the whole goddamn system. Thank God, we incorporate multiple safety valves in our algos to automatically detect an imbalance so we don’t get waxed in a meltdown. The last thing we need is pain-in-the-ass government bureaucrats thinking they have to do something to placate the public, when we know and they know, they can’t do anything to stop us. HFA trading is here to stay. They can’t un-ring the bell without bringing down the whole fucking global economy.
Trader # 2: “Yeah, we also have those pointy-headed quants giving us fits as they try to wring out a few bucks using their probabilistic models. They churn out massive volume just to cherry-pick a perceived mathematical disparity in the market. Fuck that rocket science crap. With so many damn computers and algorithms doing their own thing, traffic is getting congested. It’s too easy to trip over each other and cause a dislocation like the flash crash. Don’t get me wrong. I’m not saying I want a traffic cop looking over our shoulder; I just want these rookies to get the hell out of our way.
Trader # 3: “These yo-yos don’t understand that the expressway to easy profits on a day-in, day-out basis is old-fashioned pump-and-dump algorithms. I love the word ‘algorithm’. Eyes glaze over immediately when people hear that word. It’s like swinging a watch in front of their faces. They should only know that algorithms are nothing more than simple software routines, which a high-school dropout with half-a-brain can easily put together in his most inebriated state. Fortunately, our firm wants guys like us with advanced business degrees and computer skills to run their proprietary trading desk. It gives the appearance that we are savvy street traders who have an uncanny ability to discern the prospects of the companies we trade. Our real skill, however, is knowing how to juke investors out of a few pennies in high volume 24/7. We are rainmakers. Our cheerleaders over at CNBC think we are geniuses. Our bosses love us and our benefactors in the government love us. After all, we provide a valuable service to humanity. We do God’s work. We keep the market from crashing and protect American investments in the process. Therefore, we deserve the right to exact a ‘tax’ on investors. Our friends over at the Fed and the Treasury understand this and will pull out all the stops to protect our enterprise. It’s a win-win situation. They use us as an invaluable tool to implement economic policy and we get to bag big-time profits every single trading day. Some call it market manipulation, but that is nothing but a jealous slur on our professional integrity. I prefer to call it nuanced trading. Although, I have to admit flash trading is a little over-the-top. We get to look at a player’s hand before we make a move. God bless the SEC though. They have been studying this for years and still haven’t banned it. That’s how in the tank they are. Even if they weren’t in the tank, those idiots couldn’t hit their ass with either hand with the lights turned on.
Trader # 1: “Getting back to the flash crash for a second, I am worried that this whole thing can come crashing down around our ears. Next time, the market might plummet and stay down through no fault of our own. Our computers are programmed to react instantaneously if a dislocation is detected in the market. In some cases, like that which occurred on May 6th, we just don’t know what is causing the imbalance between buy and sell orders. The safest thing to do is step out of the way until the dust settles. The problem is our competitors are doing the same exact thing at the same exact time. Taking away 70% of the volume creates an instantaneous paucity of bid orders and causes the bottom to drop out of the market. It’s that simple and it’s not our fault.
Trader # 2: “Although we have a nice thing going, we can’t afford another crash, even a temporary one, because the public, and certainly the media, will blame us. They are already asking questions. The outcry will make our lives miserable, even with the government running interference for us. The explanation that HFA trading provides needed market liquidity, which narrows the spread between bid and ask prices, is wearing thin. The truth is most of our nuanced strategies would be totally useless without high volume, high frequency trading. The suits in our front office are excellent at deflecting criticism but the tenor of public opinion is decidedly against us. We’re already in the doghouse.
Trader # 3: “Listen, this conversation is giving me indigestion. We are safe. There is no way the regulators are going to admit they allowed nuanced HFA trading to go on for years and then suddenly discover it is illegal. The public would be outraged and take to the streets, especially after that Madoff fiasco. If they haven’t banned flash trading yet, which is out-and-out cheating, why does anyone think the SEC is going to ban our bread-and-butter pump-and-dump, front-running trading strategies? No fucking way. Besides, HFA trading is 70% of market volume. If it dries up, the market crashes. That’s just what the government does not want. We have them by the short hairs. Besides, we kick over a nice piece of our hard-earned profits to fund politicians of both parties. We are golden. We are untouchable. We are too-fucking-big-to-fail. Now, please excuse me while I wolf down this steak sandwich.”
That is why the wise guys always win.