By Paul Amery
Thursday afternoon’s wild trading in U.S. stock markets will be the subject of analysis and recriminations for some time to come. On 6 May 2010, investors witnessed the sixth-largest daily share trading volume of all time in U.S. markets, as well as the single biggest ever intraday points drop for the Dow Jones Industrial Average. But what caused the “flash crash” (named after the “flash” or algorithmic trading programmes that have been blamed by some for exacerbating price moves) is still the topic of active debate.
Some point to a “fat-fingered” trader at one of the major banks as the primary culprit, others suggest that currency market volatility might have been the trigger, while concerns over European debt markets or a “series of high-volume trades in S&P futures contracts” are also cited as possible catalysts for the market drop.
According to Nizam Hamid, head of sales strategy at iShares in Europe, “a handful of large-cap stocks in the U.S. showed large price movements, which fed through to index calculations and index levels, and in turn to a snowballing effect, with bids being withdrawn and prices moving down to very low levels. But perhaps what happened on Thursday could be seen more fundamentally as symptomatic of a lack of demand for shares at current levels. It’s similar in a way to what happened in 1999/2000 during the internet bubble, when limited supply caused share prices to rocket – except that this time it’s in reverse.”
Although ETFs and ETNs were represented disproportionately amongst the securities with cancelled trades during Thursday’s trading on the NYSE and Nasdaq, it would be unfair to point the finger specifically at exchange-traded products, says Hamid.
“I don’t see what happened on Thursday as an ETF-specific problem. It was more a market maker or exchange pricing problem. The question is whether certain stocks or ETFs should have stopped trading for a while, given the demand-supply anomalies that took place. Currently in the U.S., if one market stops trading a stock or ETF you can just go off and carry on trading elsewhere, complicating things further as the algorithmic trading programmes just carry on looking for the next available bid if they want to sell. The fact that a lot of good-till-cancelled limit orders were left in the system also exacerbated things,” Hamid explained.
Competitive pressure in the trading community to execute trades at ever-faster speeds may have contributed to the instability, according to Bart Lijnse, managing director at market maker Nyenburgh. “In the U.S. the competition to trade at ever-faster speeds has become so fierce that some people have taken out all pre-trade risk checks. There’s a popular software package that takes around 168 microseconds (millionths of a second) to run such pre-trade risk checks. But the fastest trading firms can execute in a much faster 18 microseconds, so anyone using the risk checking software is put at a competitive disadvantage. In Europe most people still use such checks, but there is increasing pressure to abandon them for the same competitive reasons as we have seen in the US,” said Lijnse.
The surge in market volatility over the last two weeks is causing capacity problems of a different type. Monday’s announcement of a €700 billion rescue plan for beleaguered European sovereign debtors led to an enormous relief rally in equity and credit markets. But as a result, certain European exchanges, notably NYSE Euronext and Borsa Italiana, have had problems coping with greatly increased trading volumes, according to one ETF market maker. “The exchanges claim that they are able to provide fast trading access, but then they should show that they are able to cope with the resulting flows,” the market maker said.
Hamid of iShares points to a fundamental change in share trading mechanics as partly responsible for the surge in traffic being faced by the exchanges. “Four or five years ago, a €60 billion trading day would have been made up primarily of large institutional block trades. Now, with the take-off of DMA (direct market access) and algorithmic trading there is a huge number of much smaller trading lots, as orders are broken down into smaller components for execution on different platforms. The exchanges’ bandwidth has to be much higher than it was before. Trading has changed fundamentally, with much more fragmentation and less visibility. As an ETF provider, we want to see more transparency as client confidence is boosted when people can see more clearly what’s going on in the markets.”
But viewing the rise of algorithmic trading as a malevolent trend, as some media commentators and politicians have suggested, would be a mistake, says Matt Holden, head of European ETF trading at Knight Capital. “Computers have brought liquidity to the markets and algorithmic programmes were providing quotes all the way down during Thursday’s market move,” said Holden. “If you removed electronic trading you’d have to go back to the bad old days of single share trades being executed mainly in large blocks, with larger bid-offer spreads. But it’s possible that some programmers may have got ahead of themselves in designing programmes to be fast to execute, without checking how robust they are in practice.”
Could similar events to those of last Thursday occur during European trading time? “Not all of the same preconditions that led to Thursday’s market plunge exist in Europe,” said Hamid. “On NYSE Euronext, for example, trading is suspended if an ETF’s price moves more than a certain percentage margin away from its net asset value. So trades at $0.001 – such as those we saw in some U.S. ETFs on Thursday, well over 99% away from net asset value – couldn’t occur on several European exchanges as trading would have been suspended.”
Jan de Bolle, head of business development at Flow Traders, concurs. “If share prices move that much then on several exchanges in Europe you go into auction mode, giving a five minute break for people to reassess their quotes.”
Frederic Ponzo, managing partner at trading consultancy GreySpark Partners, argues that regulatory intervention is needed to impose stricter controls on share trading. “At the moment you have rather meaningless, qualitative controls on market operators imposed by exchanges, saying, for example, that you need to be able to operate 99% of the time. Instead, we need quantifiable rules that say, for example, that if you’re driving at 100km per hour, you need to be able to brake to a stop within 100 metres. Such rules should be centrally imposed, for example under the European Commission's Market in Financial Instruments Directive (MiFID), otherwise they won’t work. The traditional exchanges are under severe competitive pressure from smaller, more nimble trading platforms and so there’s no way they’ll voluntarily implement shackles on their way of operating.”
“Right now incidents involving capacity constraints or trading halts are happening every other month on European exchanges,” said Ponzo.
Hirander Misra, chief executive at Algo Technologies, agrees with the need for Europe-wide rules, while emphasising that electronic trading should not be used as a scapegoat. “Volatility and market crashes took place well before the advent of electronic trading systems – take 1929, for example. What we need are consistent checks and balances across trading venues, rather than going back to the dark ages of manual or floor-based trading. Market surveillance needs to take place Europe-wide, rather than at each individual venue. The ongoing review of MiFID is a good opportunity to undertake this. The review should also address the lack of consistency in different exchanges’ rules on circuit breakers and price range checks.”
The European Commission has already announced that it will be looking at the area of high frequency trading as part of its MiFID review. Last week’s events in New York have no doubt moved this part of the review further up the Commission’s agenda. In the U.S., the Securities and Exchange Commission has been involved in a sweeping review of the equity market infrastructure since the beginning of the year.
Were computers ultimately to blame for Thursday’s mini-crash? There are already multiple theories of its cause, with little sign of consensus. But the way in which the trading of equities and ETFs is routed, reported and regulated is clearly becoming an ever-hotter issue.