On May 6, 2010, I sat in front of my computer absolutely stunned as the flash crash unfolded before my very eyes. As soon as it was available I downloaded the recording of Ben Lichtenstein’s live squawk broadcast so I would never forget the gut-wrenching terror I felt. Jim McTague’s Crapshoot Investing: How Tech-Savvy Traders and Clueless Regulators Turned the Stock Market into a Casino (FT Press, 2011) explains the constellation of events that made the flash crash possible. It’s a gripping tale.
Of the many themes in the book I decided to write about two—liquidity and internalization. (And please stifle your yawns, they’re vitally important.)
High-frequency traders claim that they provide liquidity to the markets and hence dampen volatility. We know that their activities have inflated volume. Since some of the exchanges give “sub-pennies-per-share” rebates to HFT firms, it behooves them to boost volume. “Buy and sell tens of millions of shares a day, and that fraction of a cent adds up to substantial profit.” But is this in fact no more than what a white paper referred to as hot-potato trading? “If two guys trade 1,000 shares back and forth a million times, that’s a billion shares. Did a billion shares actually trade, or did the thousand shares change hands a million times between two guys playing hot potato?” (p. 22) Upshot: volume and liquidity are not interchangeable terms.
When Waddell & Reed tried to hedge a $7 billion position in U.S. equities by selling short $4.1 billion worth of E-Minis (75,000 contracts) on the fateful day of May 6, volume didn’t seem to be a problem. But it wasn’t what it seemed: it “appeared to be larger than it was because HFT firms using 15,000 accounts were trading E-Mini contracts back and forth, several thousand times a second, to generate rebates.” And “what Waddell & Reed could not possibly know that day was that buy-side liquidity in the E-Mini had fallen by 55%, from $6 billion to $2.65 billion, by the early afternoon.” There was “an appearance of deep liquidity where, in fact, it was thinner than spring ice.” (p. 69)
HFT firms may juice volume, but they do not robotically provide liquidity, independent of market conditions. Instead, “the high-frequency trader was playing the markets the way card counters play blackjack, … providing liquidity if a market for a particular security is staked in his favor and backing off at other times.” (p. 163) On the afternoon of May 6, high-frequency traders “stopped providing liquidity and began competing for it, and that drove the price of the E-Mini S&P 500 future even lower.” (p. 219)
And yet it would be unfair to single out HFT firms as the main culprits in the flash crash. Consider the 200 brokerage houses that regularly transact customer orders in house. “Internalization on most days accounts for nearly 100% of all retail trades. The practice … is a huge profit maker for the firms. They attempt to match one customer’s buy or sell order with the buy or sell order of another customer. If the firm can’t find a trade that reflects the market’s best bid and best offer, it sends it to an executing broker. The executing broker generally takes the opposite side of the customer order because retail customers generally buy high and sell low, so it’s easy to make money off of them. In the rare instance when an executing broker demurs, he sends the trade to a dark pool—usually one owned by his firm. If the dark pool can’t execute the trade, it is deemed exhaust and sent to one of the stock exchanges.” (p. 223)
On May 6, “spooked by the wave of selling” and wanting to “get rid of their own inventories of stock, not accumulate more,” some brokerage firms internalized buy orders but sent sell orders onto the stock exchanges. (p. 224) This move naturally intensified the pressure for liquidity on the exchanges.
McTague’s book might not be as intense as Lichtenstein’s audio, and even though he has a chapter entitled “The Real Culprits” it’s not quite a detective story. Any time regulators are among the cast of characters the plot tends to flag a bit, for me at least. But it’s a tale told by a seasoned reporter (Washington Editor for Barron’s), full of insights and indignation, signifying more than we might want to admit for the future trajectory of the financial markets.