Wednesday, December 8, 2010

The Crash of 2:45 - Lessons Learnt

This articles appeared in The Edge, Malaysia: Nov 1-6, 2010

By Jasvin Josen
The previous article highlighted the events that brought on the shortest lived stock market crash in American history. There are invaluable lessons to be learnt from the crash and this article will discuss some of the notable ones.
The dark side of Automated Electronic Trading
Electronic trading was developed in the late 1980s and has turned into a market necessity today. During May 22-26, 2010, program trading was 60.8% of NYSE average daily volume. (source: Exchanges are competing with each other for the fastest processing times to complete trades. In June 2007, the London Stock Exchange introduced “TradElect” (although it was abandoned two years after due to system problems) that promised an average 10 millisecond turnaround time from placing an order to final confirmation, and can process 3,000 orders per second (source: Does Algorithmic Trading Improve Liquidity, 2008 by Hendershott, Jones, Menkveld)
As more electronic systems opened in the exchanges, market players began to launch algorithmic trading strategies to interact with the automated systems of the exchanges. Machines can react more rapidly to temporary mispricing and examine prices from several markets simultaneously. Algorithmic trading systems are used by different type of traders - high frequency traders, arbitrageurs and fundamental investors.

The benefits of automation come with risks. The flash crash of May 6 demonstrated that under stressed market conditions, the automated execution of a large sell order can trigger extreme price movements, especially if the algorithm does not take prices into account. Worse still, when computers talk to each other in a tense environment, liquidity erodes quickly resulting in disorderly markets.
The intimate relationship between stock and future markets
May 6 reminds us of how a futures market can affect a stock market in minutes. Automated trading has closely linked stock and futures where changes in one feeds through the other at tremendous speed. The SEC-CFTC report released on Oct 1 makes it very clear that the action in the e-mini futures led the sell-off in shares and ETFs.

Let us not forget that the 1987 crash was triggered by similar instruments. Back then, various funds were using program trading to perform “portfolio insurance” strategies, trading derivatives (futures and options) to dynamically hedge equity portfolios. That day, also against a stressed market background, liquidity dried up in the futures markets and the panic spread to the cash markets.

Time for circuit breakers to keep up with times
The main difference between the May 6 crash and the 1987 crash was that the present one only lasted for twenty minutes. The 1987 crash only partially rebounded two days after and took two years to recover completely, allowing the panic to spread to global markets.
The reason – subtle mini circuit breakers designed to restore order in times of panic. Orders will bypass the main exchanges to less liquid venues that take longer time to process orders. As observed, pausing a market can be an effective way of providing time for market participants to reassess their strategies, for algorithms to reset their parameters, and for an orderly market to be re-established.

This strategy ultimately saved the May 6 crash. However one can never rest on its laurels.  It is said that orders bypassing the NYSE and going to less liquid (and often manual) venues explained some of the dramatic prices seen on May 6. While the system is designed to restore order on the Big Board, the incredibly fast trading during times of panic may have swamped these less liquid venues. That's when market makers had to quote “stub quotes” which could be as low as a penny a share.

Regulators now acknowledge the need to recalibrate the existing market and plant wide circuit breakers that apply across all equity trading venues and the futures markets. In fact, circuit breaker pilot programs have already been implemented for individual securities across the S&P500 Index and the Russell 1000 index and certain ETFs.
Uncertainty about broken trades affects market liquidity
The exchanges’ decision to cancel broken trades that were trading more than 60% from the 2:40 p.m. transacted prices was only disclosed at the close of market. An observation from May 6 is that market participants’ uncertainty about which trades will be broken can affect their willingness to provide liquidity.
To provide market participants more certainty as to which trades will be broken and allow them to better manage their risks, the process for breaking erroneous trades now uses more objective standards. On September 10, the SEC approved the new trade break procedures on a pilot basis where conditions for broken trades are clearly spelled out. For example, “ For stocks priced $25 or less, trades will be broken if the trades are at least 10% away from the circuit breaker trigger price” and so on.
Exchange Traded Funds (ETFs) can be very vulnerable instruments
It is widely believed that the Flash Crash propagated so quickly to the stock market because of the popularity of the SPDR ETF that that tracks the S&P 500 index (SPY). The SPY has become the preferred instrument by arbitrageurs that trade off discrepancies between the futures and the cash markets. Since the E-mini (the most liquid equity index futures contract in the US) was tumbling ahead of the stock market, arbitrageurs started to buy the E-mini futures and sell the SPY ETF. As a result, the e-mini contract started rebounding, while the SPY was still falling.
It is not clear how the SEC intends to tackle this issue; after all, this is merely an inherent risk of any ETF that tracks a market or index.
High Frequency Traders and Flash Trading need to be watched over?
Technological advances in recent years have enabled very fast analysis of information and transfer of data. This saw the beginning of a new type of trader taking advantage of these advances: the high frequency trader (HFT).

The main strategy of HFTs is to react very quickly to tiny price changes in either direction, not to make big bets on big price changes in one direction. The large volume trades undertaken by HFTs narrows bid-offer spreads among stocks. Their fast and reliable execution speeds enhance trading volumes for U.S. exchanges, creating a healthy marketplace for price formation. Nevertheless, HFTs have been condemned for allegedly pulling out of the market on May 6, which saw stock prices suddenly plunging before recovering.

It is not clear at this point what lies ahead for the HFTs, but it appears that the SEC is focussing more on flash orders (or flash trades). Flash trades occur when exchanges send trade orders to a select group of participants (for a fee), a fraction of a second before revealing them publicly. Flash orders are offered by a number of stock exchanges, like the Nasdaq, DirectEdge and BATS Exchange. There is a likelihood that this privilege may be removed to be fair to all market participants.

Lesson for Malaysia and Asia
Many Asian markets are already offering electronic trading and some even direct algorithmic trading linking clients directly to the exchange. The Malaysian Bursa is  one of them that recently allowed UBS to launch its algorithmic trading platform on the exchange. It is a matter of time before Asia faces the same challenges of the U.S. HFTs will most certainly expand to Asia over the next several years. 

However, after the experience in the U.S., we can expect Asian markets to be more equipped with regulation and controls for automated and algorithmic trading. Perhaps this will slow down the evolution in Asian markets, but definitely make them more orderly.

The flash crash reminds us of how modern markets operate. In the words of Mr Michael Yoshikami, Chief Investment Strategist at YCMNET Advisors, “We have one firm, that according to the SEC really was the trigger of this whole cascade... When you consider the number of firms out there making trades the possibility this could happen again, in my opinion, is very high.” 

The stability of our financial exchanges will be called into question at a future time. It is just a matter of how we handle it, rather than escape it. 

At the same time, capital markets in Asia should not make the mistake of shying away from index futures and ETFs. Instead, whilst learning from the oversights of the west, Asia should concurrently allow creativity and innovation to evolve the markets naturally.

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