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The Fragility of the US Markets

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"Did you hear? The stock market broke the other day. Stocks went inexplicably haywire, costing investors millions in a matter of seconds. It appears to be the result of a single market participant."

It should frighten you to know that the quote above would have been a truthful statement roughly half a dozen times during the last two years. The United States capital markets have broken down. They no longer serve as an efficient system for allocating capital to companies. Our markets have become a playground for computer and data scientists who are trying to make their fortunes by writing advanced algorithmic trading strategies.

The changes in the U.S. markets have come over several years, but the root cause is simple and obvious -- high-speed, computerized trading systems. While these advanced technologies could be very beneficial if cautiously implemented and properly regulated, they have instead overcome our ability to truly understand and control them.

The owners of the largest market making firms have:
  • Recklessly implemented strategies that are poorly understood and not well tested.
  • Built entirely new exchanges to circumvent the restrictive regulations that tied the hands of the NYSE and Nasdaq.
  • Devoted massive lobbying resources to influencing regulations so as to benefit their style of trading.

What they have failed to realize (or choose to ignore) is that orderly markets and responsible regulation are in their long-term best interests. Instead of embracing that philosophy and working to build a stable system with meaningful reforms they focus on short-term profits above all else, and subvert the rulemaking and regulatory process at every opportunity.

The result is the U.S. stock market that stands before you today, a system so complex and fragile that individual market participants can cause extreme instability and even crash the entire market. If you have a cold, you're not allowed near the computers running the market -- a sneeze could erase a hundred billion dollars of wealth.

This should, of course, be terrifying to regulators, traders and anyone else whose livelihood depends on the efficiency and stability of the stock market. That any one individual participant currently wields the accidental power to temporarily derail an entire market is evidence that our system is woefully broken. Computer "bugs" and "glitches" make news on a regular basis. Inexplicable moves of great magnitude happen regularly on a single-stock or market-wide basis. One is left to wonder when these sorts of "mistakes" can be manufactured and manipulated for malicious purposes -- or whether such foul play has already happened before our eyes.

The most recent events on July 31 are simply the latest manifestation of a stock market that is teetering on the edge of an abyss:

  • The Flash Crash in May, 2010 was set off by a single large trade estimated at $4.1 billion in the S&P 500 Futures Market. The cascade led to 20 minutes of extreme volatility, wiping out nearly1 trillion of market cap before quickly and inexplicably recovering. The economic cost of this event is completely unmeasured, but certainly huge. We were lucky it didn't happen near the market close -- had the U.S. markets closed before they recovered, the result would have been total economic disaster as money flooded out of the stock market overnight.
  • In August, 2011 the stock market swung up and down by over 4.4% on four consecutive days, alternating up and down days. It was wild, unprecedented volatility -- only the third time in history that had happened, with the second time having been three years prior, during the crash of 2008. While the European crisis was becoming a more important issue at the time, this volatility was not warranted by major economic changes or historic macroeconomic events. This was computer-driven volatility.
  • "Mini flash crashes" occur on a near-daily basis in individual stocks. Nanex has documented over 1,000 instances of individual irregularities in stocks since August 2011. Single-stock circuit breakers have failed to stem the tide and aim to heal a gunshot wound with gauze.
  • IPO's in Facebook and BATS (itself an Exchange) have gone horribly wrong due to technological "glitches," souring the market for IPO's and costing untold thousands of jobs as companies cannot raise the capital they need to expand.
  • Few realize how lucky we were on Tuesday, July 30. An order to sell nearly $4.1 billion in the S&P Futures Market, the same size as what precipitated the Flash Crash, was executed three seconds before the market closed. There simply was not enough time for the waterfall of May 6, 2010 to repeat itself. What happens the next time when that same order is sent in a couple of minutes sooner? The SEC typically respond that their circuit breaks will save the day. Unfortunately, circuit breaks are turned-off during the last 25 minutes of trading.
  • On Wednesday, July 31, Knight Capital Group -- one of the largest market making firms, an official Designated Market Maker on the NYSE, had an algorithm pushed out that was not properly tested. The result? A loss for them estimated at $440 million, untold economic losses for retail investors with stop-loss orders in one of the almost 140 stocks that were affected, and a further erosion in investor confidence.

It's rather ironic: while market participants fight regulators tooth-and-nail over every proposed rule change and reform, retail investors head for the hills. Naturally, investor-flight has greatly accelerated since the Flash Crash. In fact, it has now turned negative when indexed to 1996.

As I've detailed in past posts, retail investors have been suffering under the current market. The economic costs of volatility, HFT algos that step in front of large institutional orders, undermined confidence, and the complete lack of a viable IPO market are dramatic. We need to take the following actions right away, and I will detail why in my next post:
  • Affirmative market making obligations for any firm that would collect a rebate on any venue where securities are transacted: ATS, ECN, Dark Pool or Exchange, it shouldn't matter where.
  • Impose a 50 millisecond minimum quote life on all quotes (for reference, the blink of an eye is about 300 milliseconds).
  • Eliminate pay-for-order-flow.
  • Enforce price-time priority across all venues.
  • Eliminate co-location and direct exchange feeds.
  • Take away the self-regulatory authority of for-profit exchanges.

The beautiful visualization of fractal images belies a more terrifying reality. Fractals are a picture of a transition between two worlds -- the orderly linear world and the chaotic non-linear world.

They are a picture of the "Edge of Chaos." The U.S. markets are on the edge of chaos right now. We've been seduced by the technological beauty of these intricately interwoven systems but are now being betrayed by the chaos and non-linearity of their interactions with each other. Some would say the tipping point has already been reached, but I'm not ready to go that far. They can be fixed, but we need to act now.