“May 6 was clearly a market failure, and it brought to the fore concerns about our equity market structure.

-Speech by SEC Chairman Mary L. Schapiro

>

What a surprise! The SEC has acknowledged that the flash crash was a structural issue:

As the Securities and Exchange Commission finalizes its report on the May 6 “flash crash,” it is being forced to confront the fallout of its own decisions—which Wall Street sought and cheered—that ushered in an era of fast trading dispersed across dozens of venues.

As recently as this spring, many were applauding the speed, lower costs and competitive nature of the U.S. stock market that largely grew out of a series of policy and technology changes over a decade . . .

What created these structural flaws? A decade of increasing de-regulaton, de-centralization, and privatizing public exchange obligations all worked to release the markets from their historical constraints.

I was somewhat surprised how readily the WSJ acknowledged that the flash crash more or less by Wall Street tinkerings with the basic trading structures. Over the past 13 years, Wall Street requested various regulations, modifications, restructurings — and they were completely accommodated by the SEC, the exchanges, CFTC, CME and others. Whether this was a case of regulatory capture, or a belief in radical deregulation movement is hard to discern at the moment.

Various Wall Street critics quoted in this article blame changes that “left markets more vulnerable to rapid and unchecked swings than had been anticipated.”

Those changes that led to the Flash Crash include the following regulatory changes:

Regulation ATS: The SEC adopted this reg in 1998 to allow for nonexchanges to execute trades electronically.

Dark Pools: The rise of private trading venues with no obligations to maintain stability and orderly markets;

Penny pricing: The 2000 SEC mandate of  pricing stocks in pennies instead of 1/8 fractions (reducing per-trade profits and incentives for traders)

Regulation NMS:  In 2005, the SEC adopted opening stock trading to greater competition, thereby ending the duopoly of the New York Stock Exchange and Nasdaq Stock Market. Goodbye specialists, hello dark pools.

Decentralized Trading Centers: Does having numerous trading centers (vs concentrated exchanges)impact stability? Apparently yes

Instantaneous bid/offer quotes: There should be minimum requirements on the duration of orders, which can be measured today in 1000s per second.

Phantom liquidity: High-speed traders do not reliably supply liquidity in a crisis.  that disappears when most needed by long-term investors and other market participants?” the release asked.

One area of discussion which I doubt the SEC will discuss is the Exchanges themselves. They are the ones who sold out the investing public, allowing the high frequency, co-located servers, quote sniffing, quote stuffing algo driven traders too steal from the public at will.

In the zero sum game that is trading, every penny in profits of HFTs comes from somewhere: Your pockets. That the NYSE exchanges would even defend this is, quite frankly shameful.

The remaining issue is what the SEC is going to do about this . . .

>

>

Sources:
Strengthening Our Equity Market Structure
Mary L. Schapiro,
U.S. Securities and Exchange Commission
Economic Club of New York, September 7, 2010
http://www.sec.gov/news/speech/2010/spch090710mls.htm

Investors, Regulators Laid Path to ‘Flash Crash’
TOM LAURICELLA, KARA SCANNELL and JENNY STRASBURG
WSJ, September 28, 2010
http://online.wsj.com/article/SB10001424052748704791004575520363764665240.html

Category: Bailouts, Quantitative, Really, really bad calls, Regulation, Trading

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

26 Responses to “Deregulation, Structural Flaws Caused the Flash Crash”

  1. Robert M says:

    It is impossible to explain how deeply these facts were ignored. When the SEC, SIG and Sandy Frucher conspired to steal away the PHLX from the members it had come after a long period of time in which the equity operation had began paying for order flow in order to stay in business. The payment issue was not nearly a unamious vote and you were severely penalized as a specialist if you didn’t pay for order flow(you received no new issues to make a market in. The debate was not academic as it was a question of what the exchange is supposed to do as a non profit, i.e. is it’s purpose to facilitate the members ability to make money or was it to make money for the exchange itself.

    The same payment issue is what drives the HST and firms that sell their order flow(doesn’t matter what product). Having been able to convince the SEC that liquidity would be enhanced by trading in pennies(who wouldn’t risk a penny?) they denied the fact that pennies dried up profitability especially in an environment in which there are multiple exchanges(dark or otherwise) trying to justify the expense of high speed servers to execute algorithms that are made void by the behavior of the algorithms(it is the equivalent of saying an ice cube on the equator will act like one inf the Antarctic during daylight hours). And this goes directly to the stupidity of the regulators and the traders, i.e. the more complex something is the risk of failure is not in the middle where it is manageable but on the third and fourth deviation moves where it doesn’t just effect the institution/operation but the whole society.

  2. ACS says:

    Stable, liquid markets do not happen spontaneously. They require effort on the part of some person or persons and they will want to be compensated for their efforts. When that was done by specialists, market makers, and locals in the pits everyone complained about the money they “took”. Now they have been disintermediated out by technology and the price is paid in a different way: illiquidity.

  3. Expat says:

    I am not convinced that regulation will solve the issue. The problem with computerized trading systems is merely the symptom of a larger financial, legal, and moral disease. Most investors are victims in the market (any kind of financial market from stocks to CDS’s). As the banks and exchanges scare off individuals, they will probably turn upon each other or find sovereign victims to fleece (again).

    In any case, we know how the system works. As the protagonists in The Big Short continuously wondered, “We know we are going to get fucked, but we just don’t know exactly how.” The true problem with this system is that the criminals have magical Do-Over Pills. Flash crash cost you a billion? Call the SEC for a do-over. Credit bubble popped and stuffed you for two trillion? Call the Fed and get free money. Your basic economic model been destroyed through your own greed and incompetence? Call the Fed and get no-risk, high yield back to back deals using taxpayer money! Wheeee!

    So, frankly, let them invent new computers, new programs, new exotic and incomprehensible financial products. Let them screw around. You will never be able to adequately regulate anything. But take away the backstop, the do-overs and the freebies and you will get auto-regulation…or at least you will kill off the worst of the lot.

  4. contrabandista13 says:

    “….One area of discussion which I doubt the SEC will discuss is the Exchanges themselves. They are the ones who sold out the investing public, allowing the high frequency, co-located servers, quote sniffing, quote stuffing algo driven traders too steal from the public at will.

    In the zero sum game that is trading, every penny in profits of HFTs comes from somewhere: Your pockets. That the NYSE exchanges would even defend this is, quite frankly shameful.

    The remaining issue is what the SEC is going to do about this . . .”

    Barry:

    The answer is nothing…. They should do nothing about this…… The HFT/Algos are cannibalizing each other. That was what the “Flash Crash” was all about…. There are far more important issues than the bullies beating the shit out of each other in the playground….. Maybe we’ll get lucky and they’ll pull out the guns… General accounting standards would be a great start, in my opinion.

  5. ACS says:

    Weren’t penny quotes pushed to help the public? There’s that old law of unintended consequences again. What are the chances that any “fix” for the so-called flash crash will not turn out the same?

  6. jpmist says:

    Great post, Barry, keep beating the drum. . .

    And I’ll reiterate what Nanex wrote– that the SEC already has rules in effect to eliminate marketing preferential access to quotes and enforce a minimum quote duration.

    http://www.nanex.net/FlashCrashFinal/FlashCrashSummary.html

  7. Dow says:

    I don’t understand why anyone would invest their pennies in the markets today when you can just walk out your door, look around, and find a local investment opportunity. Not to mention, it’s more fun.

  8. KidDynamite says:

    @Dow – well, I don’t think that’s easy to do, but that brings up another point that I think is essential to address, which someone mentioned earlier when they said that most investors are “victims” in the market.

    See, I think that most investors in the stock market 1) do little/no work on their investments 2) have little/no clue about their investments 3) expect that they can buy a few different ETFs or mutual funds and watch their money double every 8 years or so.

    Then, when things go bad, they get religious and start screaming about how unfair it is!

  9. peterpeter says:

    In the zero sum game that is trading, every penny in profits of HFTs comes from somewhere: Your pockets. That the NYSE exchanges would even defend this is, quite frankly shameful.

    Nonsense. No market participant is there to be charitable (blog writers and readers as well). There’s nothing wrong with HFT funds trying to earn a living, and of course their income is coming from somewhere… but the big losers here are human speculators and market makers that used to gouge in 1/8th increments.

    HFT has inflicted quite a lot of pain in the realm of old-school speculators, manual traders representing institutions, specialists and market makers – but has been to the benefit of investors.

    Cry me a river for the market makers and human speculators that join the ranks of horse and buggy drivers in finding new work.

    There should be minimum requirements on the duration of orders, which can be measured today in 1000s per second

    To compensate for the added risk of adverse selection on orders that could not be cancelled, HFT (and human) market makers will just widen their spreads. Costs for investors will increase as a result, and the lower expected trading volume will lead to further increases in costs to investors, as the costs of running the exchanges and regulatory bodies will be borne by fewer and fewer trades.

    One area of discussion which I doubt the SEC will discuss is the Exchanges themselves. They are the ones who sold out the investing public, allowing the high frequency, co-located servers, quote sniffing, quote stuffing algo driven traders too steal from the public at will.

    Barry, this reads exactly like something ZH would write (the kind of drivel you have recently written about). If you don’t like other market participants because they are hurting your business in some way – that’s fine (everyone talks their book, including me). But, to malign an entire group of market participants by saying they steal from the public is simply wrong. You are drinking the ZH and Themis cool-aid.

  10. I find Themis to make rational, fact based arguments based on their experiences in the market. This is no grand conspiracy, the exchanges are robbing the public.

    I am surprised you don’t think markets are a zero sum game. When it comes to HFT traders, they are scalping pennies from mutual funds. That adds up to billions — its gotta come from somewhere.

    And unlike Specialists, there is no obligation to honor a quite or insure stable liquid markets.

  11. KidDynamite says:

    Barry – one thing I find especially ironic is that you run a quant model. It uses publicly available information to try to deduce where stock prices are going. I don’t think there’s anything wrong with that.

    Now take a step back and think about what HFT does – uses quantitative models to evaluate publicly available information (and yes – this is a fact – the information is available to anyone who wants it) and try to deduce where stock prices are going. They do it on a faster scale than you do, and with a different time horizon – but in the end, they’re just another group of traders trying to do the same thing you are: figure out where stock prices are going and make money if they are correct.

  12. Kid D,

    The HFT pay the exchanges to co-locate their servers — they get to “see” what the orders are, and actually get to front run those buy and sell orders as part of their executions.

    That is simply stealing . . .

  13. ACS says:

    Barry what is your prescription for the problem? Simply banning HFT will not return the stability that disappeared along with the reign of the specialists and locals on the trading floors.

  14. I mentioned 3 of them in my Impossible Wall Street Fixes:

    3. Return to the Specialist System: The Nasdaq-afication of the NYSE turned out to be a terrible mistake. We want human specialists matching orders, making a market, stepping in during a collapse.

    7. Not-For-Profit Exchanges: The exchanges have foregone the individual investor. Instead, they are chasing fees from high frequency traders and hedge funds.

    8. Decimalization: Give up the decimals, and return to fractions. This would allow investment houses trading desks to earn a decent profit. And that might reduce their need for reckless speculation.

  15. peterpeter says:

    > I find Themis to make rational, fact based arguments based on their experiences in the market

    The “white papers” that Themis produces contain hypothetical examples that are preposterous. They mix some facts with some nonsense. As someone who writes algorithms to trade the markets, I only wish that things worked the way that they are portrayed in Themis’ “white papers”.

    Themis is losing business to the likes of Pipeline and other more high tech firms who know how to get good fills with minimal market impact while maintaining low commissions. In a world where computers rather than specialists do the trading, Themis loses business to other more technically focused competitors, so it is no shock that they rail against the perceived ills of HFT, since it is costing them comissions.

    > I am surprised you don’t think markets are a zero sum game.

    I do think markets are a zero sum game, but I believe that the sum of the profits made by all electronic market makers normalized to pre NMS notional trading amounts attributed to investors (not speculators) is far less than the same amount made by the human specialists and market makers of old. Said another way, if we were to reverse NMS and go back to trading in 1/8ths (or any regulatory changes that approximate the same outcome like minimum quoting periods), investors will end up paying more per share in commission and regulator fees.

    Markets need a source of liquidity to function well, and today’s electronic market makers have such fierce competition which has driven down the overall profits from spreads. That is a good thing for everyone except the old market makers (and other humans in the old food chain who relied on manual order flow with relatively high commissions).

    > And unlike Specialists, there is no obligation to honor a quite or insure stable liquid markets.

    An obligation that is not and can not be enforced is meaningless. Noone stands in front of a market moving hard in 1 direction and places a tight contra-side quote, regardless of what the regulations say. In the crash of 87, specialists with obligations to put in bids simply did not answer their phones… which is exactly what any rational person would be expected to do. Turning off machines on May 6th is exactly the same.

    Today’s market is not perfect – but no market has even been nor ever will be. Those who hate HFT ignore the past ills of specialist collusion and forget what commissions and fees used to be like. An investor today can go buy a narrowly tailored ETF with a load an order of magnitude below comparable mutual funds, and can trade said shares with all in commissions of 1/2 penny per share at places like Interactive Brokers. That is several orders of magnitude cheaper than the first stock transaction I made in the 80s.

    To repeat that – an investor can transact today all in with tight spreads at 1/2 a penny per share!

    The profits from HFT are rich, but they pale on a trade volume weighted and dollar indexed basis to the profits that used to be extracted from investors through the entire human chain that is now holding on by a thread.

    People keep clamoring for “fair” markets where everyone has the same access and the same data. The only way to attain such a goal is to halt all trading.

    Someone will always be closed to the buttonwood tree, always has been, and always will – provided that the tree exists. At least in today’s world, literally anyone with modest capital can put their own co-located server in place and attempt to compete. The costs for development of the software are high, but the costs to place a server in a data center are not… and pale in comparison to the barriers to entry that used to exist.

  16. KidDynamite says:

    Barry – come on – you can’t keep repeating this outright false nonsense about frontrunning and stealing:

    “Kid D,

    The HFT pay the exchanges to co-locate their servers — they get to “see” what the orders are, and actually get to front run those buy and sell orders as part of their executions.

    That is simply stealing . . .”

    That’s like me saying that YOU are stealing because you pay Morningstar, S&P or whomever for market data which I don’t buy. I’ve explained this many times: back in the day, it was impossible for anyone to get equal access to the privileges that the specialists had. Now, it’s not impossible – it’s open – ANYONE who wants to can co-locate. Open co-location is a MORE open playing field, not a less open playing field. Of course, you can’t solve any problems by banning co-location – someone will always have the data first (hey – that sounds like the title of an article I wrote! (http://bit.ly/9AFqmA)

    And no – they are not frontrunning your orders – no matter how many times you says it – I expect a higher standard of truth in terminology from you, since you’re not a market novice.

  17. peterpeter says:

    > Kid D,
    >
    >The HFT pay the exchanges to co-locate their servers — they get to “see” what the orders are, and
    > actually get to front run those buy and sell orders as part of their executions.
    >
    > That is simply stealing . . .

    Barry, this is simply not true. They pay the exchanges to co-locate their servers so that they see the orders coming out of the quote feeds as fast as possible… but that is not before the orders are put in the exchange’s matching engine.

    An exchange matching engine receives orders and tries to first execute them against contra-side orders in their book or against NBBO quotes from other exchanges (with variations based on order attributes i.e. things like whether you want your order to be able to route out or now). That happens *before* the exchange assigns an order ID to the incoming order and puts it on their books.

    It is only *after* the exchange has added the new order to the books that any information about that order is sent out on either the proprietary data feeds or consolidated into CQS or UQDF.

    Flash orders are different in that the exchange (say Direct Edge) attempts to find a contra-side party to execute at the NBBO locally for 25 milliseconds before routing out. In some cases that is to the benefit of the party that placed the flashed order since it can save them 0.3 cent per share route out fees… and when it is not to their benefit because it is leaking order flow about successive orders into the market early, they should simply choose to not route their orders to Direct Edge (it isn’t friggin hard! if you need to pick a venue to send your order to and you don’t like how your order gets handled at one venue, you simply choose to not use it).

    But, the perception that anyone co-located can see an order before it gets to the exchange and can “front run” them is pure nonsense.

    HFT see the orders before they get onto the consolidated feeds, but not before they are publicly available to anyone who wants to process the raw feeds, and certainly not before the exchange handles the inbound order.

    Every message on the raw feeds (the feeds that HFT traders process) contains an order reference number generated by the exchange… and you can’t generated a message about an order until the order reference number has been assigned by the exchange matching engine. Ergo it is absurd to claim that the HFT can see orders and beat them. Exchanges have a time priority and if a quote is distributed on the feeds, it has already been assigned an order reference number and is sitting in that exchanges’ matching engine. Another order at the same price with the same constraints from a HFT acting in response to an order in question will never trump it on that exchange. It may follow by a few micro-seconds, but it is still further down in the queue.

  18. KidDynamite says:

    but let’s talk about the fixes:

    “3. Return to the Specialist System: The Nasdaq-afication of the NYSE turned out to be a terrible mistake. We want human specialists matching orders, making a market, stepping in during a collapse.”

    specialists step in during a collapse? like in 1987? Markets have always crashed and will always crash regardless of who is making the market. you cannot legislate liquidity (you can’t force people to provide it)

    “8. Decimalization: Give up the decimals, and return to fractions. This would allow investment houses trading desks to earn a decent profit. And that might reduce their need for reckless speculation.”

    Now you’re suddenly concerned about the investment houses? Oy vey. Anyway, do you think that would be better for the individual investor? paying teenies and eighths instead of pennies? really? no thanks – I’ll take penny spreads all day long.

  19. mbelardes says:

    The Integrity of the Financial Markets has been compromised.

    What are we going to do about it?

    Vote “D” or “R” this November.

    Grrrrrrrrrrrrrrrrrrrrreeeeeaaaaat!

    BR, looking at The Big Picture, is it possible for there to be some sort of nonviolent, democratic, digital revolution in the future.

    That has to be in the cards, right?

    Imagine if America finally says, “ya know what, we need to pass an Amendment stating clearly that Corporations are not “people” deserving of constitutional rights.”

    Bloggers debate, discuss, agree. Legal bloggers draft documents. Then I hear a chime and see on my iPad/Playbook I have just received an email from the people I trust. It’s an explanation of a proposed change, a link to a place to discuss/debate further, the document in PDF format, then a place to digitally sign a ballot initiative to put it to a vote. Then I can post it for the people that trust me and my judgement to view. They educate themselves and sign it as well. Post and continue.

    Imagine the end of the 1,000 page bills full of unrelated crap that our moron congressman don’t read. Instead, Financial reform bills written not by corporations but by everyone. Hashed out online on sites like TBP. Finance guys weigh in. Lawyers weight in. Investors weigh in. Final drafts of a few dozen pages with explanations circulate. People “like” them on Facebook. We tell our congressman straight out to adopt this or else.

    I think we are progressing this direction. Information moves too fast. People are realizing very quickly that the Politicians are idiots and there are other people out there who actually care, understand what is going on, and are not up for sale.

    THAT is the only thing I can think of that will fix the structure of anything, from the Financial Markets to the US Government.

  20. ashpelham2 says:

    Having read that Wall Street Fixes blog entry, Mr. Ritholtz, I cannot say in words how much I concur with those 3 recommendations. Especially, #7, which probably would have done more to limit the damage in the flash crash than the other two you mention here.

    But respectfully, I know you aren’t realistic about having humans running those transactions ever again. Now that computers are introduced into it, there will never be a utopia where people are the ones to introduce reason into the equation. That ship has sailed and it will never port again. And your #8 recommendation is paired with that, in my opinion. Sure, some profit would be created by working with fractions, but that’s an archaic way of calculating price, and we’ll never go down that road again. This is a game that’s time is up, and I believe many individual investors are seeing through the rigged circumstances against them now.

  21. SteveC says:

    I’m confused why the flash crash was such a big deal. Unless you are a trader who uses stops, it should have been a non-event. Over the long haul, stocks will find their fair value. If you are someone saving for retirement and look at their statement 1x per month, you may have not realized it ever happened. I do not favor going back to specialists. In my opinion, they work for the biggest players on Wall Street, fleecing the little guy because they act as an intermediary with inside information about the intent behind some of the order flow. Who is selling and why? Via computerized exchanges, orders are broken into 100 share lots, with big players and little guys freely trading with each other. My only request is that everyone must hold open their bid for 1 second, with an intent to execute the order if it is filled. Exchanges should never be turned off in the event of another market disruption, so buyers can step in the void.

  22. [...] As the Wall Street Journal reports, one of the primary causes of the flash crash seems to have been improvements in trading speed and execution in recent years that were intended to improve liquidity and lower costs. But those changes helped the big players who execute algorithm-driven trades in milliseconds, not individual investors. In fact, by jumping in front of the rest of us, the high-frequency traders drive up prices. In short, the ability to do ultra-fast trades anywhere and everywhere is not necessarily a good thing for the markets. Barry Ritholtz over at The Big Picture has a good rundown of recent regulatory changes that may have led to the flash crash. [...]

  23. Andy T says:

    KD@12:22

    Agree completely with those comments. Thought some of those ideas were nutty and said so at the time:

    “It seems like a lot of the things on the this list are “command and control” type diktats BR. You’re basically determining which firms can lobby and which cannot. You’re also creating rules that increase profits for some firms at the expense of customers. You also are dictating which firms can be corporations and which cannot. Except for #4 and mabye #9, your “wish list” seems extremely “left-leaning” and mostly unconstitutional….”

  24. dss says:

    Nothing is going to be done. The study has been published, now it is time to go about your business.

    Thinking that the corrupt and incompetent SEC is going to fix anything is like thinking the Mafia is going to fix anything. As long as the revolving door between Wall Street and the SEC is used, there is zero incentive to change anything.

    Our system is broken and as long as there are profits to be made nothing will be done.

  25. ToNYC says:

    I don’t think you want to see a Specialist take a minute to drop the bid a buck the moment he let you shorted 4,000 GE. Cancel and Replace were even worse.
    However, a corollary of the Corporation > Individual paradigm would propose that no machine could act faster than the fastest human in placing a trade. People need to eat too!
    Speeding tickets are a good thing when the population is endangered by machines moving too fast to react.

  26. kaleberg says:

    Does anyone remember the old NASDAQ? It was a bunch of brokers with telephones and the motto, “My word is my bond.” To modern eyes, that’s totally quaint, especially that latter part. On the other hand, maybe it we need a new market, and nowadays most brokers have telephones. Why aren’t the big investors getting rid of the middle man? What does Fidelity, Vanguard, Calpers, Harvard or any of the other big fund managers get out of the NYSE? They should spring for a bunch of telephones, develop as set of market rules that provide for a more controlled auction with symmetric access and use that for trading, going to the NYSE or any other market only when it makes sense. Not only will they get better execution, they could run a retail business through this market on the side.

    When you are trading big blocks of stock, but only every so often, you want a totally different kind of market than when you sell relatively small blocks, but hundreds of times a minute. We don’t land 747s on country highways. Building a new market would probably take a few weeks, and if handled cleverly, it could provide better access to existing markets since it could coordinate its access to the traditional markets. The high speed traders have demonstrated that the existing markets no longer meet their customers’ needs. That opens a niche for a market that does.