Thursday, June 21, 2012

Broken Markets

I just finished the book which was very interesting, although highly detailed and technical.  I would say it was more intended for institutional investors than individual investors.  I discussed some of the initial key takeaways regarding colocation and front-running here, in a recent post.

Technically speaking, High Frequency Traders (HFTs) and option arbitrageurs are a different species, however, one thing they have in common is that they distort the markets and otherwise amplify market movements.    

The primary takeaway from the book is that the market composition has changed substantially over the past ten years. On the surface, the markets look the same - open at 9:30am and close at 4pm.  However, given the mass exodus of small investors and mass inflow of HFTs, the underlying dynamics of the markets have changed radically.  As John Bogle described recently, the stock market has gone FULL CASINO in the past 10 years - $40 trillion of annual high frequency trading v.s. $200 billion of issuance.  Meanwhile, all that trading comes at a very high price as these HFTs extract billions of profits by front-running pretty much everyone from small investors to mutual funds.  

Traditional market makers have gone out of business because the new HFTs have even better/faster colocated access to the exchanges than the market makers ever had, yet the HFTs have none of the obligations to make markets i.e. buyer/seller of last resort.  So, the HFTs pretend to be market makers aka. 'liquidity providers', but at the first sign of trouble they become 'liquidity takers' - dumping their positions back into the market.  Whereas traditional market makers held stocks overnight and maintained 'inventory' to provide liquidity, the HFTs hold zero inventory with typical holding periods measured in seconds or less.

The other key takeaway is that none of the major recommendations made to the SEC following the 2010 Flash Crash have been successfully implemented.  Some of the single stock 'circuit breakers' have been implemented, but don't seem to work (more on that below).  In other words, nothing has changed, so the risk of another crash due to order imbalance just grows with each passing day.  More to the point, the HFTs actually made a huge profit from the Flash Crash because instead of generating the usual upward momentum feedback loop, they generated a downward momentum feedback loop and then profited from the extreme 'mispricing' that resulted.  So don't expect any of those algorithms to have been rewritten.

As always, you can't make this BATshit up
The most staggering factoid which I didn't really grasp at the time, is that when the BATS ECN (exchange) went public this Spring, , because the stock crashed within minutes of being opened.  That in a nutshell is all you need to know about HFT and the current fragile state of these markets - the number one HFT-utilized stock exchange (BATS) goes public and has to withdraw its own stock from its own exchange due to a flash crash...!!!

And what have regulators done in the meantime?  Nothing.