What The Hell Happened?

It’s been over 24 hours now and still no one has any idea as to what caused Thursday’s bogus market plunge. Needless to say, that’s not good.

Yesterday’s market swerve: fat fingers, glitch, or cyber-warfare?

Theories about yesterday’s stock market swoon, where within a matter of 20 minutes, the stock market plunged by 1,000 points and then nearly completely recovered, are abounding. Fortune asked Rishi Narang, founder of the hedge fund Telesis Capital and author of Inside the Black Box, to share the theories he’s heard and handicap them in terms of likelihood and plausibility.

Narang, who uses high-frequency trading techniques, explains why high-frequency traders got out of the market during the dive, and why the catalyst for the drop is far more important to understand than the drop itself:

What happened yesterday?

There are two points to understand. First, what catalyzed the activity? What was the reason for the market wanting to fall? It might be that the catalyst was of such size that it overwhelmed all other factors. There are three plausible theories:

1) The fat finger. Plausible, but unlikely. Typing in billions with a “b” versus millions with an “m” seems impossible. Trading systems don’t work that way. More likely, the trading system accepts the sell/buy amount in thousands. Some trader in the heat of the moment forgets it’s in thousands, types in an order for 16,000,000 instead of 16,000. That kind of thing seems far more plausible.

But even then: why on Earth would the trading entry system not have a sanity check? For almost no one in the world is a $16 billion sell order okay to send out as soon as it’s entered. The trader should be fired, along with everyone in the IT department. If this happened, most likely, it was something along those lines. If it wasn’t all one order, maybe it was meant to sell just $1 billion shares but was sent 3 or 5 times instead of once.

2) Software error. Plausible, likely, but doesn’t fit the facts. Here, the trading software is in a recursive loop, pounding out sell orders due to a bug somewhere in the software. In a sense, this is more plausible, more likely, but doesn’t seem to fit the facts well enough.

The speed of the decline in the market just doesn’t seem to fit — should be a series of small orders, not a series of large orders. In 7 minutes we saw a 580-point drop. That doesn’t look like a recursive loop. But there is a lot of software, and somewhere a bug is bound to exist. You can easily imagine a software glitch happening. Things go buggy. Like the Toyota [accelerator] problem, at heart a software problem. Technology is a two-edged sword, and this is the other edge of the sword. We rely on software, but it’s not always written well enough.

3) Computer hacking. Implausible without proof, but possible. This is the most interesting theory because we know terrorists are interested in cyberterrorism. We know they would target the financial markets. We know a great day to launch an attack would be one with a mild bit of panic [due to the Greek crisis and sovereign debt downgrades].

Some other really crazy things happened with stocks, like Accenture and Exelon. [Both stocks traded for one cent for short periods of time.] Two parties really transacted on these trades [at one cent], even though they were later busted and cancelled. If it was just high-frequency traders bailing out, why wouldn’t [that drop] happen on every stock? It just doesn’t add up. Things are too idiosyncratic and that feels uncomfortable. This also happened in the options markets, but again, only on a handful of options.

And the second point to understand?

That’s the question of the enabler. What, if anything perpetuated the selloff? And did so in seconds? There’s a lot of speculation about high-frequency traders vanishing from the marketplace.

The consensus is that high-frequency guys didn’t provide the liquidity and that’s what allowed for prices like one penny on Accenture. I do know for sure that high-frequency traders backed off, but old school market makers would’ve done the same thing, in a little bit different way. They just would’ve created super-wide market spreads. Same thing.

We shouldn’t be so sanguine about taxes and impediments to high-frequency trading if we are upset when high-frequency traders leave the market. Those are incompatible ideas.

As a side point: traders have stop loss levels; one big move triggers other moves. There are systematic, discretionary, and plain-old panic trades.

But for all of those styles and programs, once they see the stock market fall 6%, a liquidation effect takes hold. That’s just a function of people. Someone screams fire, and if enough people start running, everyone will. Those are the dynamics of computer software, people, animals, fires, whatever. It’s how we work. That kind of stampeding effect could easily be part of the response.

But the speed of the market falling down, going back up, and partway back down again? If this was really a stampede, why not repeat the 1987 crash [which kept going]? Nothing ‘stopped’ this crash except that the catalyst seemed to have ended.

If it was an error or a software bug, it stopped. If it was a hack, the hackers left. In other words, the enabling side of this drop is totally irrelevant [to the catalyst]. The only interesting thing here is the catalyst. If this was a gas pedal that was stuck, it would’ve looked differently, kept going.

Whether this was intentional or unintentional, it happened all at once. If it was an intentional [attack], then the question is, was it a demonstration, a test, or the attack itself? Whatever it was, we didn’t stop it. It stopped itself.

See also:
Regulators Are Stumped by Drop
NYSE, Nasdaq bicker over stock-market drop
Plunge highlights fragmented markets, fast traders
Stock Market Crash? Or Trading Error?
Theories abound about how the 1,000 point Dow drop occurred
UPDATE: Everyone Seeks Answers Behind Stock Market’s Rout
Programs, NYSE Circuit Breakers Contribute To Market Plunge
Nasdaq cancels the trade of 296 stocks after Thursday’s Wall Street stock market crash
SEC reviewing Thursday’s sudden stock market drop
SEC Said to Outline Possible Causes of Market Plunge (Update1)
House panel to hold stock market inquiry

All I can say is that the investigators at the SEC had better get off their asses, take a break from their prodigious porn surfing, and get to the bottom of what exactly caused Thursday’s bogus market plunge. And they had better come up with a definitive answer quickly.

/the ongoing inability of exchange operators and regulators to pinpoint the problem is beginning to shake market confidence even more than the bogus plunge itself

Unfair Advantage

This shouldn’t be allowed, period.

SEC Probes Flash Orders to Ensure Fair Access to Data (Update3)

The U.S. Securities and Exchange Commission is examining so-called flash orders to ensure equity markets aren’t putting investors at a disadvantage by giving some brokerages advance knowledge about trades.

“The SEC staff is specifically examining flash orders to ensure best execution and fair access to information for all investors,” John Nester, a spokesman for the regulator, said today.

Charles Schumer, the third-ranking Democrat in the U.S. Senate, told the SEC to review flash orders in a July 24 letter. Nasdaq OMX Group Inc., Bats Global Markets, Direct Edge Holdings LLC and the CBOE Stock Exchange give information to their clients about orders for a fraction of a second before the trades are routed to rival platforms. The systems are meant to give investors an additional opportunity to complete a trade.

Last month, SEC Chairman Mary Schapiro said the agency is concerned that electronic indications of bids and offers are being disseminated to a select group of brokerages. She also said it would examine dark pools, private electronic markets operated by brokerages that don’t publicly post quotes.

The review appears unlikely to lead the SEC to impose curbs on other forms of high-speed trading, NYSE Euronext Chief Executive Officer Duncan Niederauer said today, citing discussions with regulators. NYSE Euronext, the world’s largest owner of stock exchanges, told the SEC in May that flash orders result in most investors getting worse prices.

No Fear

“I don’t think there is any fear of them doing something that would severely damage the displayed liquidity on U.S. equity markets,” he said today in a conference call with analysts to discuss the New York-based company’s second-quarter results. “High-frequency trading is actually the most consistent source of liquidity.”

NYSE is building facilities in Mahwah, New Jersey, and near London to boost its capacity to handle high-speed trades. The company is spending about $500 million, the Wall Street Journal reported today, citing people familiar with the matter.

Analysts including Raymond James Financial Inc.’s Patrick O’Shaughnessy said this week that regulators’ response to flash orders might result in restrictions on computer-driven trading, which could hurt profit for exchanges.

Bats, Nasdaq Support

Bats CEO Joe Ratterman said today in an e-mail to clients that the Kansas City, Missouri-based exchange would support an industrywide ban on flash orders. Nasdaq CEO Robert Greifeld told Schumer July 28 that his company would also support a prohibition, according to a statement issued by the New York senator’s office.

Both introduced the systems over the past three months to compete against Direct Edge, the trading platform that has gained market share through its three-year-old Enhanced Liquidity Provider program.

Direct Edge, which is not a registered SEC exchange, more than doubled its market share since November to 11.9 percent of the total volume in the U.S. in June by using revenue from its ELP program to cut other trading fees. The ELP program accounted for 8 percent of the shares handled by Direct Edge.

“If regulators get rid of it, or do anything to significantly circumscribe the program, it will hurt Direct Edge and help Nasdaq and NYSE,” Justin Schack, vice president of market structure analysis at New York-based Rosenblatt Securities Inc., said in an interview. “It takes away a big competitive weapon that Direct Edge used to gain market share.”

Wall Street and the World of Flash Stock Trades

High Frequency Trading

The computers have become traders in just the last few years, say market people. One particularly visible part of what they do is called High Frequency Trading, in which machines, programmed to look for market trends, may buy or sell a stock in milliseconds.

A subset of this phenomenon is known as “flash trading,” in which stock exchanges let firms place super-fast orders to buy or sell stocks — often based on information they receive a fraction of a second before the rest of the world does. Large firms pay fees for the advance information, and may be able to profit by moving so quickly.

See also:
ICE says it doesn’t allow ‘flash’ trading
Nasdaq backs ban on “flash” trading: Schumer
High-Frequency Trading Faces Challenge From Schumer (Update1)
Schumer wants to ban flash trading
SEC Examines ‘Flash’ Trading
BATS CEO Ratterman supports ban on flashed orders
BATS Exchange Supports Ban On ‘Flash’ Orders – CEO

And people wonder why the average investor distrusts Wall street.

/apparently all trades are equal, but some trades are more equal than others