Sunday, October 3, 2010

Flash Crash: US regulators provide their report

During the days preceding May 6, 2010, concerns about European debt issues and a potential Greek default were placing stress on global markets. On that day, US equity markets began to trade down at an accelerating pace as many systematic traders exited the markets – a factor contributing to the “Flash Crash” where stocks moved wildly and the S&P 500 dropped by 8.5% at point during the day. This past Friday, the US Securities and Exchange Commission and the Commodity Futures Trading Commission released a joint report on this matter. Several news articles are highlighting that a large unnamed trader (likely to be Kansas based mutual fund Waddell & Reed) pursing an automated futures contract trading strategy increased the instability of the markets. The regulator’s report notes that our current trading environment remains complicated because 1) there are several sources of data feeding into the markets, 2) data communication methods vary, 3) the volume of quotes, orders, and trades are high and 4) the laws of physics create inherent time lags in how information is handled.

MY TAKE: High frequency trading (HFT), according to the Tabb Group, accounts for 56% of equity trades in the US and 38% in Europe. This sub-second trading arms race is less about assessing business and economic fundamentals, and more about leveraging a mix of quantitative algorithms, high performance supercomputers, finely tuned communication networks and a server’s proximity to exchanges. The exchanges like HFT because they generate significant trading revenue (note: there are plans for co-located data centers next to exchanges in Hong Kong, India, and Australia to support HFT). Yes- the US regulators have approved “circuit breakers” that should pause trading in moments of market instability. However, it seems they remain behind the curve on the effect HFT may have on increasingly interdependent markets where speculative trading volumes are increasing and transparency is low.

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