Rajiv Sethi on Financial Market Ecology: Positive-Feedback Trading
Kirilenko et al.: "The Flash Crash: The Impact of High Frequency Trading on an Electronic Market"

R. T. Leuchtkafer on Financial Market Ecology: Positive-Feedback Trading


Comments of R. Leuchtkafer on 265-26: U.S. Commodity Futures Trading Commission Chief Economist Andrei Kirilenko and several co-authors published a paper called "The Flash Crash: The Impact of High Frequency Trading on an Electronic Market," to date the definitive examination of high frequency market makers. What Kirilenko reported is deeply troubling for U.S. markets, implying structural instability, crashes and liquidity crises large and small, toxic quotes and price discovery in the public markets, and the uncertainty of any order's likely effect on prices. His breakthrough paper is a decisive empirical justification for reforming how high frequency market makers operate in today's markets.... Kirilenko's study is the latest U.S. government agency report on scalpers.... Defining a "scalper" as a firm that "typically buys and sells in large quantities, expecting to hold the trade open only a very short time" and that "intends to be even as to quantities bought and sold at the close of the business day and is reluctant to carry a trade over night."...

In his autopsy of e-mini SP 500 futures trading around the May 6, 2010 Flash Crash, Kirilenko describes how these firms destabilize markets. There's a tipping point in volatile markets when, in an instant, high frequency market makers stampede to rebalance their inventories, even cascading positions from firm to firm, while prices collapse. Kirilenko calls this "hot potato" trading, but it's an interdealer panic, a market maker fratricide. His conclusions extend to any volatile episode, because, as he wrote, high frequency market makers "did not change their trading behavior during the Flash Crash."... Markets crashed when high frequency market makers hit internal inventory limits and unloaded onto the next market maker, which then hit limits and unloaded onto the next one, and so on, driving the market down by almost $1 trillion dollars in a few minutes. Kirilenko studied e-mini trading in the futures market, but the CFTC and U.S. Securities and Exchange Commission staff report on the Flash Crash showed the same behavior at work in the equities markets, doubtless from many of the same firms.

The scalper's destabilizing practices are that it can quote as it pleases and trade as aggressively as it pleases and still carry the regulatory imprimatur and privileges of a market maker.... Instead of smoothing buy and sell pressures, as market makers in the equities markets were -- in theory -- once supposed to do, scalpers exacerbate or hide from volatility, as Kirilenko discovered in the Flash Crash.... Registering as equities market makers, given valuable and unique regulatory preferences and access, cozying up with exchanges desperate for business, and then let loose on the stock markets, the scalper's business model makes the stock markets structurally unstable....

A recent study found that high frequency firms post the best price at least 50% of the time in the equities markets. The study's author and high frequency firms pounced on this as strong evidence high frequency firms contribute to price discovery, more so than any other kind of firm. The analysis and conclusion are superficial. A bid or offer has at least four dimensions. Beyond price and size, any resting bid or offer has a lifetime, and the inventory cycle or position resulting from any executed bid or offer has a lifetime. Even if it's at the best price, a bid or offer lasting a fraction of a second hasn't contributed to price discovery, and market makers use the latest technology to post and cancel thousands of bids and offers per second, even in the same stock. An executed bid or offer where the position is unwound quickly and aggressively isn't price discovery either. Kirilenko found high frequency market maker inventory or position half-lives of less than two minutes in the futures market. Some equities high frequency market makers claim as little as 11 seconds in their stocks. Market maker inventory cycles of a few seconds or minutes, enforced by aggressive trading as time or prices go against the firm, actively destabilize prices, especially so in already volatile markets.

Of a quote's four dimensions, only one has materially improved in the last 10 years. Because of decimalization, automation and deregulation, quoted spreads have improved for liquid stocks in stable markets. But quote duration is down, time-in-inventory is down, and for many stocks quote size is flat or down. This is all because, to manage costs, high frequency market maker inventory cycles are engineered down to seconds, and these firms keep their capital commitments low. High frequency firms will tell you they're like any other business except that capital is their inventory, and like any other business they make money by turning over their inventory, so they churn it as fast as they can. Frenetic trading isn't a byproduct of their strategies -- it is the strategy. The effect of all of this is that investors looking at a quote today can't predict what the quote means. They can't tell whether the quote will be there when they submit an order against it, and they can't tell when their own buying or selling will trigger a market maker's risk threshold. If they do trigger a threshold, the market maker cartwheels from liquidity supplier to liquidity demander to compete with an investor's own liquidity needs. As it cartwheels, it can shock prices. And when events align so market makers turn as a flock, as they did in the Flash Crash, they can collapse the market....

As has been said, an insight from the Flash Crash is that "volume is not liquidity." A further insight is that, batted about by scalper inventory microcycles, published quotes don't represent genuine liquidity either. A best bid today isn't a bid to own shares at a price, or even a traditional dealer or market maker's attempt to provide liquidity. As much as 50% of the time it's just a firm trying to scalp a few basis points as quickly as possible. When that scalper's bid is executed, it then becomes an unexploded competitive liquidity demand, with the timer set, as Kirilenko found, at about two minutes, or even less. These destabilizing trade practices are a fundamental structural instability behind the Flash Crash....

The equity market reforms and deregulation of the last 10 to 15 years happened for good reasons -- monopoly profits were flowing to intermediaries and exchanges, intermediaries were taking advantage of their customers, innovation was being strangled by entrenched interests -- and it was time for reform. As many of us hoped, new participants, technology and business models sprang up. Nobody wants to undo that progress. By analyzing trade and position data from the futures market, Kirilenko's breakthrough was to show how a dominant class of these business models can be disruptive, and how these models can be destabilizing enough to create systemic risk as an inherent consequence of their design. On a gross basis, these models can be checked by circuit breakers or price limits, and this is one reason price limits are standard in the futures markets. In the equities markets, these models must be checked even before they trigger circuit breakers or price limits because the equities markets are profoundly different from the futures markets. The simplest way to check these models is to put reasonable restraints and obligations on them.

A basic function of any market is to produce a quote. The scalper's toxic quotes, thousands of them a second, are a hoax on our equities markets. No one planned it. It happened as an unanticipated consequence of well-meaning reforms to a flawed system. There is no competitive solution to this problem within current regulations so long as quote price is a routing table's first regulatory imperative. Competition simply forces exchanges to publish more and faster toxic quotes, as market power continues to shift from the exchanges to the scalpers.

Finally, some have pointed out that regulation didn't work in the market break of 1987, when old-fashioned specialists and market makers shirked their responsibilities and hid from the market, and regulation won't work today. Regulation didn't stop them from shirking their responsibilities, but regulation didn't excuse them either, and regulation didn't encourage them to automate a deadlier game than hide-and-seek -- intermediaries didn't exacerbate the 1987 market break by playing market maker "hot potato," a feat unique to the Flash Crash. And the logic of "regulation didn't prevent 1987, so regulation won't work" is a civic novelty. Should we apply that logic to drunk driving, or to any other misbehavior?

Of course not. Please regulate them.