Tag Archives: Market liquidity

Here's The Official Flash Crash Report; Scapegoat Found

“In summary, our analysis of trades broken on May 6 reveals they were concentrated primarily among a few market participants. A significant number of those trades were driven by sell orders from retail customers sent to internalizers for immediate execution at then-current market prices,” the US Commodity Futures Trading Commission and the US Securities and Exchange Commission concludes in their just released report on the so-called “flash crash” on May 6th this year. And they seem to have found a scapegoat:

“At 2:32 p.m., against this backdrop of unusually high volatility and thinning liquidity, a large fundamental trader initiated a sell program to sell a total of 75,000 E-Mini contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position.”

US Commodity Futures Trading Commission – US Securities and Exchange Commission


“This large fundamental trader chose to execute this sell program via an automated execution algorithm (“Sell Algorithm”) that was programmed to feed orders into the June 2010 E-Mini market to target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time. The execution of this sell program resulted in the largest net change in daily position of any trader in the E-Mini since the beginning of the year,” the report says.

The “large fundamental trader” have been identified as the 73 years old investment firm Waddell & Reed.

“Only two single-day sell programs of equal or larger size – one of which was by the same large fundamental trader – were executed in the E-Mini in the 12 months prior to May 6. When executing the previous sell program, this large fundamental trader utilized a combination of manual trading entered over the course of a day and several automated execution algorithms which took into account price, time, and volume. On that occasion it took more than 5 hours for this large trader to execute the first 75,000 contracts of a large sell program,” SEC and CFTC notes.

Adding: “However, on May 6, when markets were already under stress, the Sell Algorithm chosen by the large trader to only target trading volume, and neither price nor time, executed the sell program extremely rapidly in just 20 minutes. “


Sell Pressure

According to the report, the sell pressure was initially absorbed by:

1. High frequency traders (“HFTs”) and other intermediaries8 in the futures market;

2. Fundamental buyers in the futures market; and

3. Cross-market arbitrageurs9 who transferred this sell pressure to the equities markets by opportunistically buying E-Mini contracts and simultaneously selling products like SPY, or selling individual equities in the S&P 500 Index.

“HFTs and intermediaries were the likely buyers of the initial batch of orders submitted by the Sell Algorithm, and, as a result, these buyers built up temporary long positions. Specifically, HFTs accumulated a net long position of about 3,300 contracts. However, between 2:41 p.m. and 2:44 p.m., HFTs aggressively sold about 2,000 E-Mini contracts in order to reduce their temporary long positions. At the same time, HFTs traded nearly 140,000 E-Mini contracts or over 33% of the total trading volume. This is consistent with the HFTs’ typical practice of trading a very large number of contracts, but not accumulating an aggregate inventory beyond three to four thousand contracts in either direction.”

“The Sell Algorithm used by the large trader responded to the increased volume by increasing the rate at which it was feeding the orders into the market, even though orders that it already sent to the market were arguably not yet fully absorbed by fundamental buyers or cross-market arbitrageurs. In fact, especially in times of significant volatility, high trading volume is not necessarily a reliable indicator of market liquidity.”

What happened next is best described in terms of two liquidity crises, the report says.

A Double Squeeze

“The combined selling pressure from the Sell Algorithm, HFTs and other traders drove the price of the E-Mini down approximately 3% in just four minutes from the beginning of 2:41 p.m. through the end of 2:44 p.m. During this same time cross-market arbitrageurs who did buy the E-Mini, simultaneously sold equivalent amounts in the equities markets, driving the price of SPY also down approximately 3%,” the regulators write.

“Still lacking sufficient demand from fundamental buyers or cross-market arbitrageurs, HFTs began to quickly buy and then resell contracts to each other – generating a “hot-potato” volume effect as the same positions were rapidly passed back and forth. Between 2:45:13 and 2:45:27, HFTs traded over 27,000 contracts, which accounted for about 49 percent of the total trading volume, while buying only about 200 additional contracts net.”

At this time, buy-side market depth in the E-Mini fell to about $58 million, less than 1% of its depth from that morning’s level. As liquidity vanished, the price of the E-Mini dropped by an additional 1.7% in just these 15 seconds, to reach its intraday low of 1056.

“This sudden decline in both price and liquidity may be symptomatic of the notion that prices were moving so fast, fundamental buyers and cross-market arbitrageurs were either unable or unwilling to supply enough buy-side liquidity,” the report explains.

In the four-and-one-half minutes from 2:41 p.m. through 2:45:27 p.m., prices of the E-Mini had fallen by more than 5% and prices of SPY suffered a decline of over 6%.

“The second liquidity crisis occurred in the equities markets at about 2:45 p.m. Based on interviews with a variety of large market participants, automated trading systems used by many liquidity providers temporarily paused in reaction to the sudden price declines observed during the first liquidity crisis. These built-in pauses are designed to prevent automated systems from trading when prices move beyond pre-defined thresholds in order to allow traders and risk managers to fully assess market conditions before trading is resumed,” the report says.

A Flash Back

Okay, before I continue, let’s relive the historical – and totally crazy – 20 minutes on the afternoon of May 6th. (Cut down to 10) as the old saying that “pictures are best on radio” once again proves its infinity:

A Triple Dose

According to the US regulators, there’s also three important lessons to be learned from the May 6th event.

#1. “One key lesson is that under stressed market conditions, the automated execution of a large sell order can trigger extreme price movements, especially if the automated execution algorithm does not take prices into account. Moreover, the interaction between automated execution programs and algorithmic trading strategies can quickly erode liquidity and result in disorderly markets. As the events of May 6 demonstrate, especially in times of significant volatility, high trading volume is not necessarily a reliable indicator of market liquidity.”

#2. “May 6 was also an important reminder of the inter-connectedness of our derivatives and securities markets, particularly with respect to index products. The nature of the cross-market trading activity described above was confirmed by extensive interviews with market participants (discussed more fully herein), many of whom are active in both the futures and cash markets in the ordinary course, particularly with respect to “price discovery” products such as the E-Mini and SPY.”

#3. “Another key lesson from May 6 is that many market participants employ their own versions of a trading pause – either generally or in particular products – based on different combinations of market signals. While the withdrawal of a single participant may not significantly impact the entire market, a liquidity crisis can develop if many market participants withdraw at the same time. This, in turn, can lead to the breakdown of a fair and orderly price-discovery process, and in the extreme case trades can be executed at stub-quotes used by market makers to fulfill their continuous two-sided quoting obligations.”

Withdrawal Symptoms

The regulators have conducted a series of interviews with market participants involved in the May 6th flash crash.

According to the interviews, almost everyone says they use a combination of automated algorithms and human traders to oversee their operations.

As such, data integrity was cited by the firms we interviewed as their number one concern, the report points out.

“To protect against trading on erroneous data, firms implement automated stops that are triggered when the data received appears questionable.”

“One way of identifying potentially erroneous data is to screen for large, rapid price moves. For example, it was reported that the rapid decline in prices of the E-Mini, starting around 2:40 p.m. triggered data-integrity pauses in trading across a number of automated algorithms. Rapid declines in individual securities also contributed to data-integrity concerns and triggered trading pauses. Collectively we refer to these as “price-driven integrity pauses.”

“It is important to note these types of pauses are not necessarily the result of erroneous price data, but instead are based on prudential checks into the possibility that large, observed price changes are the by-product of a system error. In fact, the large price declines simultaneously observed across securities and the E-Mini contract during the afternoon of May 6 were indeed real.”

Very High – Very Low

The high frequency trading have been suspected as a possible cause of the flash crash.

However, the SEC/CFCT report can’t confirm or dismiss the accusations.

“Of the HFTs we interviewed, we did not find uniformity in response to market conditions on May 6. Although some HFTs exited the market for reasons similar to other market participants, such as the triggering of their internal risk parameters due to rapid price moves and subsequent data-integrity concerns, other HFTs continued to trade actively. Among those HFTs that continued to trade, motivations varied, but were in part based on whether they thought their algorithms would be able to operate successfully (profitably) under the extreme market conditions observed that afternoon.”


“In summary, our analysis of trades broken on May 6 reveals they were concentrated primarily among a few market participants. A significant number of those trades were driven by sell orders from retail customers sent to internalizers for immediate execution at then-current market prices. Internalizers, in turn, routed these orders to the public exchanges for execution at the NBBO. However, for those securities in which market makers had withdrawn their liquidity, there was insufficient buy interest, and many trades were executed at very low (and sometimes very high) prices, including stub quotes.”

I guess the econotwisted way to sum this up will be:

On May 5th 2010 all the money in the US stock market disappeared for some reason – and after about 20 minutes they suddenly came back, for some reason….

Here’s a copy of the report.

Have fun!

Select Your Language:

Arabic * Chinese * Danish * English * French * German * Hebrew * Italian * Japanese * Norwegian * Portuguese * Russian * Spanish * Swedish * Turkish

4 Comments

Filed under International Econnomic Politics, National Economic Politics

HFT Turns To Low Liquidity Stocks

In the last edition of Markit Magazine, two representatives for the high frequency trading business share their thoughts on this controversial issue. Jose Marques, managing director and head of equity electronic trading at Deutsche Bank together with Punit Mittal, global head of electronic trading, Daiwa Securities Capital Markets discuss the pros and cons of HFT.

“ High-frequency trading is predominantly focused on highly liquid names though there is an evolution towards applying the same statistical techniques to the lower liquidity end of the market and securities with less turnover and more inherent trading risk, as these stocks are harder to exit.”

Jose Marques

“High-frequency trading is like a chicken and egg scenario. Does it provide liquidity to markets or do traders only enter markets that are liquid enough for them to make money?” Mr. Mittal at Daiwa asks. High-frequency trading can offer increased market liquidity and greater efficiency. The two heads of electronic trading offer their insights on its role in market-making.

Jose Marques

Jose Marques (Deutsche Bank): High-frequency technologies promote market efficiency by providing an exchange-like service, which tightens spreads, increases liquidity and allows profit-taking.

Strategies that focus on the passive side of a trade are an important liquidity provision for the market.

These tend to be statistical trades with relatively short horizons and the goal is to make money through spread capture and market rebates received in the
course of posting orders.

With market latency arbitrage, high-frequency trading technologies work to keep prices in line when there are different quotes on different venues.

Other strategies, with mean holding periods of a few seconds or minutes, help remove inefficiencies from the market, such as a relative mispricing between securities.

This could be an exchange-traded fund (ETF) versus a basket of stocks or between stocks that have a high degree of correlation with each other. Speed matters, independent of the holding period horizon and trading objectives.

Take for example, an index or ETF arbitrage strategy, where traders are making markets based on observed prices in the underlying securities.

The Need For Speed

When there is a significant enough price movement, traders want to react quickly and update their quote.

The need for speed is not based on how quickly you accumulate your position because you are on the passive side of the trade. It has more to do with when new information comes into the market and how quickly you can take down your old quote and replace it with a new quote that reflects that new information.

In order-driven markets, bids and offers never arrive simultaneously, so
there is always a need for a liquidity provider, i.e. the economic agent that
bridges the mismatch in time between buy demand and sell demand.

Historically, human market-makers have filled the role of providing a continuous quote to help facilitate trading.

However, as technology and regulatory innovation, such as Regulation National Market System, has allowed markets and trading to become faster, so the human market-makers’ ability to quote effectively has become harder to accomplish.

Machines and algorithmic processes have largely supplanted the human-driven liquidity providers and high-frequency technologies are now filling the role as the specialists and market-makers of old.

The result is probably a substantial net increase in efficiency of US equity markets, in terms of spreads coming in and frictional costs falling.

“High-frequency trading is predominantly focused on highly liquid names though there is an evolution towards applying the same statistical techniques to the lower liquidity end of the market and securities with less turnover and more inherent trading risk, as these stocks are harder to exit.”

Though there has not been an explosion in volume in these smaller stocks, that same level of automation we see in the high liquidity sector is being introduced.

However, the amount of high-frequency trading is limited by the amount of long-term turnover.

The role of the high-frequency trader is to accumulate that liquidity and
deliver it to the buyside by matching trades over small horizons.

If that buyside trader is not there, then the high-frequency trader cannot provide the service.
In the race to capture the modern market-maker – the high-frequency trader – and be the fastest venue, exchanges have possibly overlooked their key regulatory responsibility and obligation to provide orderly markets.

Exchanges have been reticent to put in place risk and limit checks and circuit
breakers to halt or slow trading that would have prevented the great and
sudden price dislocations seen on May 6th 2010, a largely avoidable event.

“Part of what exacerbated the situation on May 6th was high-frequency traders not being able to easily understand what was going on and so they stopped providing liquidity. This led to price movements being greatly exaggerated and so over the horizons they transact, high-frequency traders actually create genuine liquidity and damp volatility.”

A Chicken And Egg Scenario

Punit Mittal

Punit Mittal (Daiwa Securities Capital Markets Co Ltd): High frequency trading is like a chicken and egg scenario.

Does it provide liquidity to markets or do traders only enter markets that are liquid enough for them to make money?

I believe it is a bit of both, though many strategies depend on very liquid markets in both cash and derivatives.

As there are more execution venues in the US to trade, we have seen liquidity grow in US equities, which has also provided more arbitrage opportunities
for high-frequency players.

We have seen the same impact in Europe after the introduction of Markets in Financial Instruments Directive with more venues emerging, such as Chi-X and Turquoise, and high frequency trading playing a big role in generating liquidity and market-making on these platforms.

*

Read the full post at The Swapper:

Related by the Econotwist:

The Ultimate Trading Weapon

“Artificial Intelligence” To Be Implemented In HFT

The Rise Of The New Market Makers

US Stock Markets Infected By Malicious Software?

Ex-Physicist Leads Flash Crash Inquiry

Testimony Of A High Frequency Trader

May 6. 2010: “The Black Thursday”

Living In A Derivative World

*

3 Comments

Filed under International Econnomic Politics, National Economic Politics

HFT Turns To Low Liquidity Stocks

In the last edition of Markit Magazine, two representatives for the high frequency trading business share their thoughts on this controversial issue. Jose Marques, managing director and head of equity electronic trading at Deutsche Bank together with Punit Mittal, global head of electronic trading, Daiwa Securities Capital Markets discuss the pros and cons of HFT.

“ High-frequency trading is predominantly focused on highly liquid names though there is an evolution towards applying the same statistical techniques to the lower liquidity end of the market and securities with less turnover and more inherent trading risk, as these stocks are harder to exit.”

Jose Marques

“High-frequency trading is like a chicken and egg scenario. Does it provide liquidity to markets or do traders only enter markets that are liquid enough for them to make money?” Mr. Mittal at Daiwa asks. High-frequency trading can offer increased market liquidity and greater efficiency. The two heads of electronic trading offer their insights on its role in market-making.

Jose Marques

Jose Marques (Deutsche Bank): High-frequency technologies promote market efficiency by providing an exchange-like service, which tightens spreads, increases liquidity and allows profit-taking.

Strategies that focus on the passive side of a trade are an important liquidity provision for the market.

These tend to be statistical trades with relatively short horizons and the goal is to make money through spread capture and market rebates received in the
course of posting orders.

With market latency arbitrage, high-frequency trading technologies work to keep prices in line when there are different quotes on different venues.

Other strategies, with mean holding periods of a few seconds or minutes, help remove inefficiencies from the market, such as a relative mispricing between securities.

This could be an exchange-traded fund (ETF) versus a basket of stocks or between stocks that have a high degree of correlation with each other. Speed matters, independent of the holding period horizon and trading objectives.

Take for example, an index or ETF arbitrage strategy, where traders are making markets based on observed prices in the underlying securities.

The Need For Speed

When there is a significant enough price movement, traders want to react quickly and update their quote.

The need for speed is not based on how quickly you accumulate your position because you are on the passive side of the trade. It has more to do with when new information comes into the market and how quickly you can take down your old quote and replace it with a new quote that reflects that new information.

In order-driven markets, bids and offers never arrive simultaneously, so
there is always a need for a liquidity provider, i.e. the economic agent that
bridges the mismatch in time between buy demand and sell demand.

Historically, human market-makers have filled the role of providing a continuous quote to help facilitate trading.

However, as technology and regulatory innovation, such as Regulation National Market System, has allowed markets and trading to become faster, so the human market-makers’ ability to quote effectively has become harder to accomplish.

Machines and algorithmic processes have largely supplanted the human-driven liquidity providers and high-frequency technologies are now filling the role as the specialists and market-makers of old.

The result is probably a substantial net increase in efficiency of US equity markets, in terms of spreads coming in and frictional costs falling.

“High-frequency trading is predominantly focused on highly liquid names though there is an evolution towards applying the same statistical techniques to the lower liquidity end of the market and securities with less turnover and more inherent trading risk, as these stocks are harder to exit.”

Though there has not been an explosion in volume in these smaller stocks, that same level of automation we see in the high liquidity sector is being introduced.

However, the amount of high-frequency trading is limited by the amount of long-term turnover.

The role of the high-frequency trader is to accumulate that liquidity and
deliver it to the buyside by matching trades over small horizons.

If that buyside trader is not there, then the high-frequency trader cannot provide the service.
In the race to capture the modern market-maker – the high-frequency trader – and be the fastest venue, exchanges have possibly overlooked their key regulatory responsibility and obligation to provide orderly markets.

Exchanges have been reticent to put in place risk and limit checks and circuit
breakers to halt or slow trading that would have prevented the great and
sudden price dislocations seen on May 6th 2010, a largely avoidable event.

“Part of what exacerbated the situation on May 6th was high-frequency traders not being able to easily understand what was going on and so they stopped providing liquidity. This led to price movements being greatly exaggerated and so over the horizons they transact, high-frequency traders actually create genuine liquidity and damp volatility.”

A Chicken And Egg Scenario

Punit Mittal

Punit Mittal (Daiwa Securities Capital Markets Co Ltd): High frequency trading is like a chicken and egg scenario.

Does it provide liquidity to markets or do traders only enter markets that are liquid enough for them to make money?

I believe it is a bit of both, though many strategies depend on very liquid markets in both cash and derivatives.

As there are more execution venues in the US to trade, we have seen liquidity grow in US equities, which has also provided more arbitrage opportunities
for high-frequency players.

We have seen the same impact in Europe after the introduction of Markets in Financial Instruments Directive with more venues emerging, such as Chi-X and Turquoise, and high frequency trading playing a big role in generating liquidity and market-making on these platforms.

However, Asia has not seen high frequency pick-up to such a great extent, largely because liquidity in the region is not good enough but also due to market structure and regulation.

Nonetheless, high frequency is active in Australia, to a certain extent in Japan, after the Tokyo Stock Exchange’s launch of its next-generation trading system Arrowhead, and in markets such as Korea, which has one of the most liquid index futures and options markets in the world.

In evaluating the impact of high frequency trading in the US, we find advantages and disadvantages.

On the plus side are increased liquidity provisioning, narrowed spreads among certain stocks, faster and more reliable execution speeds and enhanced volumes to US exchanges, suggesting a healthy market for price formation.

The downside includes increased intraday volatility in some stocks, adverse selection for some market participants and higher implementation shortfall costs.

However, separating the effect of higher implementation shortfall costs attributed to the financial crisis as opposed to high-frequency trading
adoption is challenging.

“There is also some concern that high-frequency trading generates low quality liquidity, that it can generate false trading signals creating more noise trading and at times disrupt the markets through “rogue algorithms”.

In this grand game, low-tech institutional trading firms are complaining about the unfair playing field afforded to these high-frequency, high technology players.

Indeed, many traditional money managers do not trade against high frequency desks due to the fear of being outplayed by traders who are trying to take advantage of every possible arbitrage opportunity.

However, if there is an arbitrage opportunity in the market then that suggests that markets are not that efficient, so having different technologies, adding different styles of trading and different types of investors helps to make the market a more efficient venue to trade.

The Reality

“The reality of the new, evolved electronic trading environment is that the new trading rules are now based on technology more than ever. High frequency technologies have pushed every player to become more innovative and continue to improve their infrastructure to be able to trade on multiple markets.”

If we look at latency numbers, we are talking today in terms of microseconds
and even nanoseconds on some exchanges and alternative execution venues, something we never imagined even a few years ago.

The market has evolved from an open outcry method to sub-microsecond latencies and this has only been possible because high frequency players have pushed the boundaries and enforced innovation in financial technology.

Benefits derived from the development in infrastructure are not purely for
the high-frequency community; they have also been rendered to the traditional money managers as well.

For instance, if Daiwa creates a very low latency system, it provides the same service to its other investors, not just high frequency specialists, so they can trade much faster and capture better prices and liquidity. High frequency trading can introduce an outstanding level of volume to the market.

Index arbitrage or statistical arbitrage strategies or simply capturing the price movement on a stock, may result in traders turning over one security 50 to 100 times a day, which contributes greatly to liquidity and volumes.

This is probably one reason why the alternative venues and exchanges are so keen on bringing more high-frequency players on board because they contribute to overall volume and naturally to the fees generated for these equity trading platforms.

Download a copy of the article here.

Related by The Swapper:

The Ultimate Trading Weapon

“Artificial Intelligence” To Be Implemented In HFT

The Rise Of The New Market Makers

US Stock Markets Infected By Malicious Software?

Ex-Physicist Leads Flash Crash Inquiry

Testimony Of A High Frequency Trader

May 6. 2010: “The Black Thursday”

Living In A Derivative World

*

1 Comment

Filed under Technology