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 are snippets of the 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.