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What We Learned from the May 6th Market Plunge

Posted by Larry Doyle on May 11, 2010 7:55 AM |

Like leading sheep to the wolves, the manner in which high frequency trading activity has grown to dominate our equity markets is nothing more than a trap. How has that trap worked? Stay on message and continue to promote the premise that high frequency trading adds liquidity to the market. Time and time again, America would hear from quantitative traders and their analysts engaged in high frequency trading that these programs would provide consistent liquidity from which retail investors would benefit.

What a crock!! That said, the HFT activity itself is not to blame for the market plunge. The programs behaved as they were designed. That is, during periods of extreme volatility, those running the programs would simply shut down the machine. Is that liquidity? No, I don’t think so.

Never again should America have to listen to anybody engaged in high frequency trading and hear them say these systems provide liquidity to the market. They don’t.

While we learned that high frequency trading activity does not provide liquidity to the market, we also learned that regulators themselves have once again shown themselves to be incapable and incompetent of truly protecting investors. Talk that regulators will institute circuit breakers and such to lessen the fall of the markets will work to protect exchanges, but will they work to protect investors? Bloomberg addresses this topic in writing, Exchanges to Report Back to SEC on Proposal for Circuit Breakers:

Heads of the biggest U.S. trading venues will submit plans to federal officials this week for shutting down stock markets nationwide during investor panics.

NYSE Euronext, Nasdaq OMX Group Inc., Bats Global Markets Inc., Direct Edge Holdings LLC, International Securities Exchange Holdings Inc. and CBOE Holdings Inc. are negotiating the threshold of gains or declines at which trading should stop, according to two people familiar with the matter. Their chief executive officers met yesterday with Securities and Exchange Commission Chairman Mary Schapiro in Washington.

“You have to agree in advance on the point at which a short-term circuit breaker would be put in,” said John Coffee, a law professor at Columbia University in New York. “We may want the circuit breaker to kick in on a 5 percent decline.”

These circuit breakers may serve to break the fall, but they do not address the core problem. What is that? The simple fact that the exchanges themselves are set up as for profit entities. That structure has caused them to provide a variety of incentives to dealers to garner their trading activity. In the process, the system itself has been built not to serve investors but to serve the dealers and the exchanges themselves.

The executives could provide no clear explanation for the selloff, according to the people, who asked not to be named because the meeting was private. None saw evidence that the plunge began with a trading error. CNBC citied “multiple sources” in reporting May 6 that New York-based Citigroup Inc. may have entered a mistaken transaction that contributed to the plunge. Citigroup said it found no evidence it was involved in an erroneous order.

The erroneous story of a “fat finger” causing an out trade is also an indication that the industry itself, served by the charade at CNBC, is not truly interested in protecting investors but rather saving face.

That is not news.

LD

  • Petric456

    Wholeheartedly agree with your points here… It was very interesting to watch the depth in the market literally evaporate on May 6th. There needs to be some sort of solution which keeps HFT shops honest. Perhaps a minimum number of trading days each year in which the NYSE operates as a “slow” market? Randomize the days as to not let HFT shops get too comfy? Its would be next to impossible from a legal perspective to direct where volume goes, but I think everyone would agree that watching markets drop 9% in a flash is not beneficial for the long-term health of U.S. markets.

  • Randy

    How about we instead convert the exchanges over to non-profit organizations, ban HFT and eliminate all co-location and volume rebate schemes and conduct annual independent audits to confirm a level playing field for all? It is time we stopped playing by the rules that benefit only the big players and do what is right and honest for all.

  • Petric456

    HFT is market making evolved, so it has some benefit. However, you can’t have bids evaporate like they did on March 6th. Basically we just need something to keep the computer programmers honest. Sadly, pandora is out of its box in terms of trading technology so if we can at least keep the programmers in check that is our only hope. Good luck in getting Mary Schapiro to read code and even better luck trying to get a publicly traded entity to go private. Would set a nasty precedent.






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