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
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withdrawn and prices moving down to very low levels.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
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
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
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
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