Tuesday marks the fourth anniversary of the "Flash Crash" of May 6, 2010, when the Dow Jones Industrial Average (INDEXDJX:.DJI) plummeted more than 700 points in minutes, at one point dropping nearly 1,000 points for the day, before sharply rebounding. The breakdown exposed flaws in the electronic U.S. marketplace.
Martha Stokes, chartered market technician, co-founder and chief executive officer of TechniTrader, spoke to International Business Times about what caused the infamous Flash Crash, current weaknesses within the U.S. stock market, and whether a similar event could be looming just around the corner.
IBT: What caused the Flash Crash?
Stokes: The Flash Crash was caused by a specific situation. There was a fundamental investor who accidentally placed orders on the millisecond scale rather than on the time-weighted price scale over a period of several months. He flushed in a whole lot of orders and there was no one to fill on the opposite side, and so the stocks started collapsing.
It really wasn’t a high-frequency trader that ran the market down. It was a fundamental trader who was selling for the long term who accidentally entered the wrong order type and it triggered it on volume when the market was already depressed and moving down. It caused this cascading domino effect from the futures emini market to the SPY market and then into the stocks. Then arbitragers came in.
There was insufficient liquidity, even though there were Liquid Replenishment Points where the market paused. There was just not enough liquidity in the market. I think they failed to realize that high speeds and lots of volume activity doesn’t mean there’s sufficient liquidity.
IBT: What safeguards have been put in place since then?
Stokes: They have new rules in place. They have new curbs. They pause and slow down the activity, and those curbs have been working successfully since then and there hasn’t been a major crash of that nature. The SEC now has the data and high-speed computers to identify it quickly to slow it down and keep it from causing damage.
There are a lot of things that have been put in place by the SEC since then. One of them is their Midas, where they’re able to go down to the millisecond and identify exactly what that transaction was and who did it. They’re able to do that very quickly. When the first Flash Crash occurred, it took them months to sort through and figure out exactly what happened and they have documented that. You can find it on the SEC website -- minute by minute, second by second what actually happened. They have detailed it, but it took them months because they didn’t have the Midas system up.
Now that they have the Midas system up, within a few minutes or a few hours they can know exactly what’s happened so they can quickly adjust the markets if it is a Flash Crash. They can reverse those orders that were accidentally pulled into that Flash Crash, and so fewer people will get injured by that.
They had curbs then, but the curbs did not trigger on that day. All the curbs that were supposed to slow if something drops, for example, 2 percent, 5 percent or 10 percent, those curbs were supposed to pause the market activity and not allow anyone to trade. That didn’t fire off.
They now have Liquid Replenishment Points, which is another point where the stock will pause trading for a minute, five minutes to try to slow down so that liquidity can come back in on the opposite side. So it’s not an issue of speed or volume, it’s a problem of liquidity on one side or the other. There becomes this extreme imbalance.
IBT: In his new book, “Flash Boys,” Michael Lewis claims high-frequency trading has at times been exploited by banks and hedge funds to give them an extra advantage over retail investors. What were your thoughts on his claim the U.S. stock market is "rigged," and are HFTs front-running retail traders and retail investors?
Stokes: I think he lacks a lot of knowledge. I think ... he doesn’t have a lot of experience in the stock market. He doesn’t understand the market structure and how it works. He has no concept that there are nine market participants, not just three. The problem was that he was focused on a couple of companies using one exchange, which I feel is very odd because a lot of the companies, like a sell-side company such as Royal Canadian Bank, would probably have several venues that were offered to them that they could have used, just using the one exchange.
You have to remember that high-frequency traders are exchange activity computers that are automated generated orders. So it’s a computer algorithm that triggers on certain news events, a certain flow of quantity share lots. That’s why dark pools, the wisest in the mutual funds and pension funds, don’t trade on the exchanges anymore. They’ve been trading on the dark pools, the alternative trading systems, heavily since 2005 because they want to avoid the high-frequency traders.
The high-frequency traders are in demand by the exchanges because they provide liquidity as make[rs] or takers. In other words, the exchanges are paying them to provide liquidity since so many market makers have gone out of business because the decimals have shrunk the spread between the bid and the ask so much that it’s almost impossible to make any money on it as a market maker [now] that the high-frequency traders that trade a thousand or 3,000 times per second on the millisecond scale are able to pull a penny off or a half penny off and have about a 51, 49 percent profitability ratio. So they just do it in huge quantities to make up so that they can make money.
They’re not making a lot of money on big spreads or anything like this, so the exchanges are basically employing high-frequency trading companies to provide liquidity because the dark pools have pulled so much of that liquidity off into the alternative trading systems.
In the U.S. market, there are many venues, many places where you can buy and sell stocks. Stock exchanges are only one area, and I believe they were speaking of one exchange and the front-running was occurring on that particular exchange. In other words, the big large lot orders were coming through and they were seeing that and so that triggered the high-frequencies to tick up a penny or a half penny above that before the others got through, and then they would sell to that larger lot, and that’s called front-running.
Retail brokers tend to fill their orders from their retail clients which are your online traders, retail traders or your retail investors, they tend to fill their orders through their inventories as they have for many years. They’re doing more so than ever, so retail traders and retail investors, are they getting front-runned by the high-frequency traders? No. they’re mostly being filled by their own broker. So their own broker may be ticking up the price on them, but if you only have very small share lots that you’re trading, you probably would not get a better fill on the exchange anyway.
There are a lot of things going on. A lot of different venues. There’s over the counter. There’s block sales between banks and corporations and banks and institutions. They’re off the exchanges. There’s more off the exchange activity then on the exchange, and this “Flash Boys” book really focused on just exchange activity. So the high-frequency traders are something that’s big on the exchanges. They account for a little under 50 percent of all the activity, and so that’s what they focused on, but that’s not the entire market. That’s one small area. NASDAQ accounts for about 22 percent of the total volume, which is very little, and the New York Stock Exchange is far below that. Dark pools account for about 9 to 10 percent right now. And over the counter is huge. So most of the transactions are not occurring on the exchanges where the front-running has been occurring. Retail traders don’t need to worry about that unless they are day trading or intraday trading and then yes, they can be affected by that.
IBT: What are dark pools and why do they exist?
Stokes: Dark pools are off-the-exchange, over-the-counter transactions. They can occur between a sell side and a buy side. Sell side being big banks, money center banks like Bank of America, Wells Fargo, Citigroup, that type of thing, and a corporation or an institution. An institution is either a mutual fund or a pension fund or a small fund. It can be a transaction between a corporation who wants to buy or sell its own stock, and a sell-side institution like Goldman Sachs. There are institution-to-institution transactions, in other words, one institution like Vanguard wants to sell a few millions shares of IBM to rotate and lower its outstanding holdings on IBM. So it will offer it out and then Fidelity might pick it up. So there’s those transactions.
The reason it’s called dark is because on the exchanges, all the order that are coming up, all the offers are there where everybody can see it on the limit book. In the dark pools, those listings are not done because what they’re trying to do is avoiding having other computers like the HFTs see that large lot order for 500 shares and then front-run it and push it up. So all of the activity is called dark rather than lit. Exchanges are lit venues and the alternative trading systems that are over the counter are dark pools.
Dark pools have been around for 40 or 50 years. These are just over-the-counter transactions between institution and institution or a company and a bank and they used to be done in the back rooms quietly whenever it was necessary to be done. There used to be in the '90s where if you were a day trader you could see the large lots coming through. Now you can’t see those. So day trading as a retail trader is very dangerous because you don’t know what’s really going on. You’ve got HFTs on the millisecond and the dark pools are off where you can’t see them.
IBT: “Flash Boys” has drawn more attention to dark pools by questioning whether high-speed traders are gaining unfair market advantages. Are dark pools really the issue? How are retail investors impacted by high-frequency trading and who benefits from dark pools?
Stokes: Dark pools are not the problem they’re making it out to be. I have no idea why people are so negative about dark pools other than the people who want to front-run them. Ok, that’s why they want to get rid of the dark pools so the retail trader and the professional trader, and everybody who wants to front-run those huge lots will do so. They tried to do that in the 1990s and the early 2000s and the institutions got fed up with it. They said, “Look, we manage $90 trillion of worldwide money. We are the most important of all of the investors. We are in investing on behalf of the small investor who buys mutual funds. We are investing on behalf of the pension funds holders. We are the most important.”
The institutions are the most important investors. They’re long-term and they want to buy at the level that they want to buy it at. They have a controlled bracketed order that they use and it’s a price range. They’ll say, “Buy me in if the stock gets up to $15, but don’t buy me in above $17.50.” So they have this price range that they buy. If they’re accumulating 10 or 20 million shares of stock they can’t buy it all at once. They have to slowly over several weeks period of time. So dark pools are beneficial if you’re a mutual fund holder/investor or a pension fund holder. You want dark pools to be around because then they can get the best price. They don’t get better than the national best bid offer, but they’re never front-runned.
IBT: In April of 2013, the Twitter account from the Associated Press was hacked with a tweet saying "Breaking: Two Explosions in the White House and Barack Obama is injured." The Dow Jones Industrial Average plunged more than 128 points in seconds after the report, though recovered quickly when the tweet was found to be false.
Was this a good test for the new measures and safeguards the SEC has put in place since the Flash Crash?
Stokes: I think it was a good test of the system and it showed there was a lot more durability and strength in the system. It highlighted that a lot of market makers are now using more human contact.
I was thinking about this discussion and I wanted to liken it to this: If you’re traveling on a commercial airline and there are 300 people on the airplane. We all know that the airplane has automatic pilot, but there’s still a pilot and a co-pilot in the seats that can take over for the automatic pilot for this commercial aircraft. During the flight, most of the time it’s on autopilot and the plane is flying itself, but you still have that pilot and co-pilot sitting there in case something goes wrong, and that’s what wasn’t in place in 2010. There was no human being there. If that fundamental trader who put these orders in had sat down and watched those orders going through, he would have realized instantly that he made a mistake. Instead he put the orders in and walked away, assuming the computer algorithm would take care of it for him.
A lot of the market makers are keeping more human contact and watching and monitoring instead of just letting the computers run randomly because even with the automated systems that we have, such as the liquidity replenishment points, you still need the human there to watch since the computer is not capable of making the assessments that a human would in order to start shutting some things down.
IBT: What current risks do you see in the stock market?
The highest risk I see it this. The retail online brokers now fill nearly every single order from a retail trader or retail investor. They internalize all of their orders. This is legal to do, but it used to be that they sent a good chuck of them to the exchanges. Now they fill them all.
One of the things that was a contributing factor to the Flash Crash, and some of these other big downtrends that we see suddenly, is that the online brokers are acting as over the counter market makers for their customers that are retail traders and retail investors, but they can also choose to push all of that selling.
If there’s a big selloff and retail traders and retail investors panic and start selling, instead of selling those orders internally, suddenly, they shove all of that back onto the exchanges. Well, then you have a situation where the market voids. The market efficiency inverts and suddenly you don’t have efficient liquidity to fill on the exchanges.
They’ve done this several times. So I think the SEC really needs to look at online brokers because the online brokers either have to function as market makers and always sell those orders, or I would prefer that they push those to the exchanges instead of filling them all themselves.
IBT: Is another Flash Crash looming in the future?
Yes. I don’t think it will be as fast. That was unusually fast in 2010. Stocks lost nearly 60 percent of their value in nearly 20 minutes. Stocks went from their normal price range down to a penny while others jumped to over $100,000 per share. It was just extreme.
I don’t think you will see those types of extremes, but you will see sudden downturns unless the SEC can solve the liquidity issue. The liquidity issue is we’re going too fast. The markets have become so efficient that they are at times too efficient and they invert. So instead of efficiently filling the orders, efficiently at good speeds, the speed gets too fast. The volume flow is too heavy on one side, and so the market efficient inverts. Then you have this temporary period were there are way more sellers or buyers on one side. One side of the market is huge with liquidity and there’s nothing on the other side. They need to fix that, and until I see that they have fixed that, we do have some risk of a Flash Crash. How great? Pretty low, but you can never rule out that something like that would happen.
If suddenly China imploded and there was a run on the Chinese real estate market or the shadow banks, that would cause a panic that could cause a sudden Flash Crash. Not as fast as this one, but definitely a panic mode that people would go into. That’s one area that we’re most vulnerable right now.
It’s not if, but when China has a bank crisis or a real estate crisis, then that could cause a potential big market downturn that could cause a void, not enough buyers or liquidity to fill the sell side.