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 The
highly discussed and quickly forgotten Flash Crash was an omen of what lies ahead
for the financial markets. It was a uniquely distinctive occurrence relative
to anything we’ve ever experienced. Likewise, what we are about to
witness will be startling and never before observed by this generation of
investors. After only thirty days the Flash Crash signal has become
unambiguous and historians will wonder why the public didn’t react
sooner to its clarion call.
Prior
to the May 6th Flash Crash I laid out what to expect in “Extend & Pretend: Shifting Risk to the
Innocent”. The ink was barely wet before
its predictions began to rapidly unfold. The
basis for the predictions was the similarities between the rally we have
experienced since March 2009 and the rally prior to the 1987 crash. It was
striking in comparison to the amount of rise, the rate and the pattern, but
more importantly the reason for both rallies. The 1987 crash was attributed
to Portfolio Insurance. In 2010 it’s about what is referred to as the
‘son-of-portfolio insurance’ or Dynamic Hedging.
Over
the last ten years we’ve systematically accelerated the shifting of
risk through the advancement of three new strategies; Dynamic Hedging,
Capital Arbitrage and Regulatory Arbitrage. Individually they may seem sound
but when pyramided as we have done over this period of time, they set the
stage for systemic instability. The underlying bedrock of this shaky
pyramid is Dynamic Hedging.
For
the full research paper: see TIPPING POINTS
The
three new strategies:
Dynamic
Hedging
Reduces
Risk further through recent advancements in High Frequency Trading and Dark
Pools (1)
Capital
Arbitrage
Hides
Risk by removing it from financial balance sheets
Regulatory
Arbitrage
Moves
Risk to Sovereign entities.
I
won’t explore in this article how these strategies are being used and
how they are building upon themselves (see “Extend & Pretend:
Shifting Risk to the Innocent”) but
rather I want to focus on what the Flash Crash is signaling and how it
relates to the three critical flaws of all modern trading algorithms.
The
chart above and the May 17th Wall Street Journal confirmed the
rational for our April predictions:
On
May 6, "The velocity of the volatility was stunning, beyond anything I
had ever seen, with the exception of October of 1987, when I was on the
trading floor," said Ted Weisberg, president of Seaport Securities in
New York. "There's a strong parallel between the Black Monday
crash and the flash crash," said Michael Wong, an analyst at Morningstar
who tracks stock exchanges. On Oct. 19, 1987, the Dow Jones
Industrial Average tumbled more than 20%, and the swoon extended into the
following day, before a rebound. Floor traders, working by telephone,
dominated the action and computer-generated trading was still in its infancy.
Dark pools and high-frequency trading were the stuff of science fiction.
Trading reached 600 million shares, according to the SEC.
Fast
forward to May 6, 2010: The worst part of the lightning descent lasted
roughly 10 minutes and the decline hit 9.8% at its worst. Trades, many
executed in milliseconds, reached 19 billion shares. In both cases,
troubles first appeared in the stock futures market, which precipitated a
decline in the regular "cash" market. The two created a feedback
loop, dragging both markets lower. Perhaps the most concerning parallel
was how professionals abandoned the market. In 1987, some human market-makers
on the floor of the exchange stopped providing bids for certain stocks.
Two
decades later, in a market dominated by technology, high-speed traders who
often provide liquidity for the market, just switched off their computers.
Other big players, including fast-trading hedge funds, also pulled out of the
market, according to traders and exchange officials.
"Go
back to the 1987 crash, every major firm pulled out," said Chris
Concannon, a senior partner at Virtu Financial LLC, a New York electronic
market making firm, which continued trading during the May 6 turmoil.
"In every break you find evidence of major firms withdrawing their
buying and selling interest from the market." (2)
The
Financial Times on June 1st wrote:
Traders
were stunned. “We thought a big European bank was about to go under,
that this was it,” says a dealer who was on one of the big trading
floors at the time. “Everyone got on the phone. Then, traders quickly
realised that the falls were due to lots of automated sell orders. At that
point we all just wanted to reach for the emergency button and press
stop.” While there have been times in equity markets where
some stocks have moved wildly, the afternoon that has become known as the
“flash crash” was the first time that the entire US
equity market was convulsed by such turmoil. But 20 minutes
later prices had bounced back. Trades that took place during that dramatic
slice of the hour where the movement was more than 60 per cent were
cancelled. Yet the impact of the flash crash will be felt for a long time to
come, not least because it showed that the equity markets do not have such
an emergency button, or any way to halt trading when something goes haywire.
(3)
MESSAGES
OF THE FLASH CRASH:
Liquidity
Driver
Dynamic Hedging and Portfolio
Insurance are both based on trend following mechanics. Consequentially both
have a strong bias towards momentum correlation and the ability to adjust to
changes in momentum.
One of three flaws in most
mathematical algorithms is the assumption of market liquidity. When markets
breakdown, liquidity quickly evaporates and this often makes execution
impossible. The more serious the breakdown the more serious the liquidity
problem will become. Also, the liquidity issue is often simultaneously
seen across multiple markets where modern dynamic hedging operates.
The Flash Crash confirmed that
Dynamic Hedging has now been modified by major players to take this into
account and this is why the algorithms ‘grabbed’ as much
liquidity as fast as it could, at accelerating rates - while liquidity was
still available. The employment of High Frequency Trading has now emerged as
a strategic imperative within state-of-the-art Dynamic Hedging Systems.
Counter
Party Risk Driver
A second flaw of trading
algorithms and markets is counter party risk or the sudden failure of a
counterparty to deliver a contracted obligation. With banks & financial
institutions still having serious amounts of off balance sheet risk tied to
Structured Investment Vehicles (SIVs) and corporations to Special Purpose
Entities (SPEs) the ability to rapidly shift hedging on any early indications
is now paramount.
Shifts in LIBOR, TED Spread, and
OIS-Swap spread must now be acted upon in milliseconds. The Flash Crash
occurred when all these input drivers were moving as a result of the Euro
crisis.
Sovereign
Debt
Changes in Sovereign Debt Ratings
have a profound impact on collateral calls associated with the $430 Trillion
Interest Rate Swap market. Collateral Calls are typically tied to Credit
Ratings, LIBOR, Spreads and Asset Values. Hedge positions on Trillion Dollar
portfolios must now be repositioned in minutes versus days or even hours
while high volume liquidity and price is available.
Instability
A third flaw of trading algorithms
is their assumption of ‘continuity’ or continuously operating
markets. Instability of any system can lead to compounding results or
exponential change until the function reaches a point of discontinuity. The
Flash Crash was the most severe of a number of market moves lately that evidenced
higher amplitudes, shorter frequencies and steeper rates of change which are
signs of instability in the market.
As
much as the market became fixated on the Flash Crash, what has received
little attention are the dramatic “Flash Dashes” where markets on
close for example are seeing 20 handles on the S&P. For long term traders
these are worrying tell tales. To others they are evidence of accelerating
and compounding Dynamic Hedging issue.
“The
real shocker is that it was nothing nefarious that caused the crash,”
says David Weild, senior adviser to Grant Thornton and former vice-chairman
at Nasdaq. “It was acceptable investor behaviour – people
trying to put on hedge transactions,” he believes. “The
market had a mini-meltdown in an instance when it appears no one was
intentionally trying to manipulate the market. It’s disturbing that it does
not take a lot to cause these markets to cascade.” (3)
The
flash crash confirmed the suspicions of those investors and regulators who
had long worried that complicated trading systems, fragmented trading across
some 40 different venues, and the enthusiastic embrace of super-fast trading
with computers spitting out thousands of buy and sell orders in microseconds,
could threaten disaster.
Indeed,
the flash crash taps into a debate that has been simmering for years between
those who see benefits created by the rapid advance of technology – by
lowering barriers to entry for new participants and boosting liquidity for
investors who wish to trade – and those who fear it has introduced
unknown risks into the system.
The
events of May 6 revealed that while getting rid of old-style
“specialist” market makers has reduced the cost of trading by
narrowing bid-ask spreads, the benefit has come at a cost. Now, no one has an
obligation to provide prices for all shares all the time during a trading
day, as trading has fragmented across an array of electronic trading venues
and traders. The moment the markets grow too risky, many new electronic
market makers appear only too willing to head for the exit. (3)
CATALYST
It is
readily apparent that present day markets have built across-market dynamic
hedging machinery with a hair trigger. This trigger is designed to
launch unimaginable trading volumes in less than 250 microseconds, across
global exchanges, operating under different & still uncoordinated rules.
The activation could be any number of events but my sense is it will stem
from the dramatic contraction in money supply. Despite massive central bank
actions, money supply as measured by MZM, M1, M2 is still de-accelerating and
in the case of the difficult to obtain M3, is contracting. All of which is
presently going unheralded by the mainline media.
When a
highly leveraged system is built on the basis of liquidity and liquidity is
shrinking, it is only a matter of time.
CONCLUSIONS
Flash
Crashes and Dashes will become more apparent. By their very nature they are
de-stabilizing. When certain natural frequency boundary conditions are broken
the markets will eventual seize up, despite all circuit breakers and attempts
by authorities to stabilize markets. These boundary conditions are not
presently understood nor seen to exist. For practitioners of Chaos Theory
they are a basic tenet to understanding any phase shift.
We are
nearing a ‘phase shift’ in what I will refer to as the energy
level of the markets. Elliott Wave practitioners would refer to it as a
‘higher degree pivot’. W D Gann practitioners would call it a
Gann Cardinal. Economists call it a “Tipping Point”. I call it a
‘Critical Point’ or ‘Chaotic Transient’.
A
trader would just call it a market melt-down or melt-up! Few alive have ever
witnessed either.
For
further insight I would refer you to my previous article: EXTEND & PRETEND -
Manufacturing a Minsky Melt-Up
Sign Up for the
next release in the EXTEND & PRETEND series: Commentary
The previous
EXTEND & PRETEND article: EXTEND & PRETEND:
Its either RICO Act or Control Fraud
SOURCES
(1) 05-18-10 Financial markets regulation: The tipping point
VOX
(2) 05-17-10 How the 'Flash Crash' Echoed Black Monday
WSJ
(3) 06-01-10 Stock markets: That sinking feeling
Financial Times
REFERENCES
Caplan,
Keith, Robert P Cohen, Jimmie Lenz, and Christopher Pullano (2009), “Dark Pools of
Liquidity”, PriceWaterHouseCoopers,
Alternatives Newsletter.
Gorham,
Michael, and Nidhi Singh (2009), Electronic Exchanges: The Global Transformation from Pits to
Bits, Elsevier.
Krause,
Reinhardt (2008), “Dark Pools Let Big
Institutions Trade Quietly”, Investor's Business Daily.
Patterson,
Scott, Kara Scannell and Geoffrey Rogow (2009), “Ban on Flash Orders Is Considered by SEC:
Schapiro Sees Inequity While Exchanges Wrestle for Market Share in High-Speed
Trading”, The
Wall Street Journal, 5 August.
Schlegel,
Kip (1993), “Crime in the Pits: The Regulation of Futures
Trading, American Academy of Political and Social Science
Securities
and Exchange Commission (2009a), “SEC Issues Proposals to Shed Greater Light
on Dark Pools”, October 21.
Securities
and Exchange Commission (2009b), “Strengthening the Regulation of Dark Pools”,
SEC Open Meeting, October 21.
Younglai,
Rachelle and Jonathan Spicer (2009), “US SEC says "dark pools" are
emerging risk to market”, Reuters, 18 June.
Gordon T. Long
Tipping
Points
Mr. Long is a former senior group
executive with IBM & Motorola, a principle in a high tech public start-up
and founder of a private venture capital fund. He is presently involved in
private equity placements internationally along with proprietary trading involving
the development & application of Chaos Theory and Mandelbrot Generator
algorithms.
Gordon T Long is not a
registered advisor and does not give investment advice. His comments are an
expression of opinion only and should not be construed in any manner
whatsoever as recommendations to buy or sell a stock, option, future, bond,
commodity or any other financial instrument at any time. While he believes
his statements to be true, they always depend on the reliability of his own
credible sources. Of course, he recommends that you consult with a qualified
investment advisor, one licensed by appropriate regulatory agencies in your
legal jurisdiction, before making any investment decisions, and barring that,
you are encouraged to confirm the facts on your own before making important
investment commitments.
© Copyright 2010 Gordon T Long. The information herein was
obtained from sources which Mr. Long believes reliable, but he does not
guarantee its accuracy. None of the information, advertisements, website
links, or any opinions expressed constitutes a solicitation of the purchase
or sale of any securities or commodities. Please note that Mr. Long may
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before investing in any security based upon statements and information
contained in any report, post, comment or recommendation you receive from
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