For every argument lauding electronic trading’s contributions to efficiency, there is a blooper reel. One specific instance of algorithmic trading and HFT contributing to negative pressures on the market involved the biggest one-day decline in the history of the Dow Jones Industrial Index- although prices recovered within minutes.

Jumpin’ Flash Crash

Throughout the day of the Flash Crash, stock prices had been declining due to concerns over the European Debt Crisis. At 2:32pm, according to the SEC and CFTC joint report called “Findings Regarding the Market Events of May 6, 2010,” a large “fundamental trader” executed a sale of $4.1 billion worth of e-Mini, an equity index futures contract with a notional value of 50 times the S&P 500. The firm used an “automated execution algorithm” which targeted “an execution rate set to 9% of the trading. At first, the principle buyers of these securities were HFT firms. Since HFTs prefer to trade a lot of contracts without building up much inventory, they quickly sold those long positions. Remember the fundamental trader used an algorithm set to execute at 9% of trading volume, and the HFTs buying and selling would invariably increase volume. Therefore, the fundamental trader’s algorithm executed the sell order faster, completing it in about 20 minutes. The sudden imbalance of trades towards sales contributed to price declines and triggered pauses in many firms’ automated trade execution systems. In the “Lessons Learned” section of the joint report, the SEC and CFTC noted that algorithmic trading of a large sell order “can trigger extreme price movements” and can “quickly erode liquidity” in the marketplace.

Concluding thoughts and the future of fair markets and HFT                                     

In this blog’s most recent post, I highlighted the efficiency of electronic trading. From lower bid-ask spreads to smaller trade sizes, electronic trading has made the movement of capital within markets faster and, some argue, easier. Turning to high-frequency trading, this practice has shown what should be an assumption of well-functioning markets: without regulation, firms with sufficient capital will find the most expedient ways of turning a profit. The tool itself is not the source of evil, in fact, it might have contributed to lower commissions. All of this has been mentioned in earlier blog posts. However, the system is not without regulation.

Regulation NMS, or National Market System, made sure of four things, one of which is directly relevant to the current discussion:

• Order Protection- this was described earlier as NBBO, or the right of investors to buy or sell at the best price they can that exists in the markets. (Source: Investopedia)

 This rule focuses on protecting the investor, specifically giving the smaller investors the same rights as institutional investors.  As we have seen in dark pools, best described in the eponymous work Dark Pools by Scott Patterson, the NBBO is not always followed to the letter in practice. The answer here is not the elimination of a practice, which if harnessed, could potentially increase liquidity in the market. The answer is regulation.

Keynes’ mention of animal spirits referred to human behavior which affected the performance of the general market. Shiller’s book of the same name later added to this discussion of reigning in the excesses of human nature. Shiller and Akerlof suggested government regulation as the answer, and this author agrees. Brad Katsuyama made the most insightful point that HFTs can be slowed down in order to reduce their advantage on the individual or even institutional investor. His exchange, IEX, may not be perfect, and Michael Lewis mentions that it has found HFTs probing its weaknesses. Brad Katsuyama, however, is not the answer.

"Allen Iverson is the answer, not me."

Regulation should be devoted to curbing the ability of HFT firms to front-run orders. The slow-market arbitrage that HFTs take advantage of should force the exchanges themselves to use the quickest feeds processed by the fastest technology, so that the information presented by the exchanges is accurate and up-to-date. Since regulation needs only to address the front-running, and eventually the relationship between lack of transparency and lack of fairness within dark pools, the SEC needs only find a way to slow down HFTs or restrict their ability to see customer orders before they reach all the exchanges they are meant to. (Source: Animal Spirits by Shiller and Akerlof)

The arbitrage between slow-updating exchanges can and should be exploited to create more efficient markets, but when that becomes predatory, efficient markets can become unfair markets. For the typical  investor, remember these firms will typically try to exploit the differences in cents between trade orders, and you should be working with a much higher margin of safety than that. For traders there has been no better advice than “follow the white rabbit.”

Happy trails and may your trades be of the highest frequency