Sharing the Flash Crash Pain

Rob Daly, SST

At this week's Best Execution USA conference, the topic of the day was the "real" cause of the May 6 Flash Crash.

It didn't take long for most conference attendees—comprising institutional investors, sell-side traders and exchange officials—to admit they doubted that a single 75,000-contract trade for the E-Mini S&P 500 was responsible for that day's events. And, of course, there was a lot of finger-pointing at almost everyone connected to trading—the mutual fund traders used a poorly designed algorithm, high-frequency traders and market-makers stopped making markets, retail brokers stopped internalizing retail order flow and the greedy retail investors flooded the market with stop-loss orders.

One lone proprietary trader blamed media coverage for blowing an intraday price swing out of proportion and making it more important than the failure of Lehman Brothers.

However, the Flash Crash is important. It's a clarion call of what market participants can expect from the markets in the future if radical changes aren't made.

It also answers the unvoiced underlying question: Who will step in and save the markets when they begin to crash and burn? The answer is no one.

When the US Securities and Exchange Commission (SEC) trotted out Regulation NMS, the theory was that the market-makers would continue to provide liquidity without having an official obligation to do so. At the time it seemed practical since the number of market-makers has exploded to approximately 400.

Yet this latest crop of market-makers can fall into two basic types—the high-frequency traders and the deep-pocketed investment banks. Although the high-frequency traders can easily generate billions of dollars in trading volume, the dirty little secret is that they tend to be under-capitalized. According to one high-frequency trader at the conference, these firms may only have $50 million. When the market starts to fall, that amount of capital is hardly a speed bump.

Then there are the large market-making global investment banks, which will step away from unprofitable trading like they did in May.

Once the SEC eliminated the various exchange market-makers’ obligation to make markets, it let the genie out of the bottle.

These firms now act as any other investor, and since most of them have a fiduciary responsibility not to squander their stockholders’ capital, they will pull out of the market once their risk management systems start sounding the klaxons. To compound the problem, instead of just stopping trading, they will eliminate their existing positions so that they will not hold anything overnight.

What's worse is that those firms that look to help halt falling markets by picking up some bargain trades and providing upward pressure on the market face a good chance to have those trades broken by the exchange or regulators in the days that follow.

The SEC's industry-wide circuit breakers might momentarily arrest a stock's decline, but buy-side firms hate the idea. When they want out of a position, they want out of it now, according to many Best Execution USA attendees.

Due to the current environment in Washington DC, there is little political will to take on another major market overhaul and the industry and regulators are going to have to file this under “buyer's remorse.”

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