There Is A High Risk Potential Of An Uncontrolled Algo Selling Feedback Loop

  • Due to their inability to process nuanced fundamental information HFT may trigger surprisingly large drops in liquidity that exacerbate price declines, and result in flash crashes,
  • Additionally, the growing lack of traditional, human market-makers has made the market increasingly fragile,
  • We normally witness a collapse in market liquidity around critical, market-moving events when HFTs strategically “pull out” from the market, making price swings especially sharp and resulting in a spike in volatility,
  • In a post-Reg NMS world we have witnessed a relentless, and increasingly commoditized ascent of HFTs, as well as the change to market structure and topology,
  • As a result:  “liquidity is the new leverage”,
    • Financial leverage was obviously the imbalance that built up during the pre-crisis period, but that has been contained in the current cycle.
    • In this cycle, there have been dramatic shifts in the way that secondary markets source liquidity, but this market structure has not yet been stress-tested by a recession or major market event.
    • Markets are paying too little attention to liquidity risk, much as they previously paid too little attention to the risks posed by excess leverage.
  • There will come a day “with actual bad news” when the selling onslaught is so broad, not even BTFD HFTs will be able to resist the sudden avalanche of selling. That’s the day when the increasingly fragile market, one in which “liquidity is the new leverage” will officially break and stocks will “trade outside of the NBBO constituting a genuine flash crash” in a “negative feedback loop that causes more volatility.” A selloff from which there will be no “snap back.”

RECENT SELLING PRESSURES

  • One of the main culprits who have been identified for the relentless selling in recent weeks has been the all-encompassing category of "algo traders", which for the sake of simplicity (if not necessarily accuracy) includes
    • Quants,
    • HFTs,
    • CTAs and trend-following strats,
    • Risk-parity
    • vol-targeting funds,
    • Passive investors and
    • Numerous other signal and factor-based market participants.
  • The nearly 20% drop in the S&P can be blamed in part on algos and the biggest threat is that "algo-driven, risk-parity fire sale in equities and credit continues."
  • DB now places uncontrolled algo-selling above such conventional concerns such as a global economic slowdown, a spike in the dollar, a semi-failed Treasury auction, a spike in US yields and/or inflation, quantitative tightening, Italy's fiscal situation, a housing market crash, a Chinese crash, and so on
  • As a result of the dominance of algo trading, momentum has emerged as the most important force in markets.
  • One key reason why current trading has become so complicated for most, and certainly the algos, is that there is currently virtually no momentum in the market - with the MTUM ETF which tracks momentum stocks having its worst month and quarter since its 2013 inception - results in making any attempt to piggyback on the market a money-losing trade.
  • "The nature of the challenges facing the market, therefore, is itself a type of risk, as their unquantifiability discourages investors from buying risk assets, because they don’t know how to hedge them. We’re in an unusually difficult situation - the fact that there are so many topics on this list (DB's 2019 Risk List), and that they are so diverse, tells you something important about the market."

However, the biggest risks listed by DB are in the final analysis the last two:

  • Fed and ECB re-start QE and risky assets don't rally, and
  • Monetary and fiscal policy are out of ammunition and the world experiences a Minsky moment.

Deutsche Bank Lists The Top 30 Risks To The Market In 2019, And One Surprise

Back in May, with the shock from February's VIX explosion still fresh in traders' minds, Goldman's Chief Markets Economist Charlie Himmelberg became the latest Wall Street strategist to admit the threat to the market posed by HFT. Picking up where our original warning from April 2009 left off, the Goldman strategist warned that HFTs – due to their inability to process nuanced fundamental information - may trigger surprisingly large drops in liquidity that exacerbate price declines, and result in flash crashes, something we have observed previously on countless occasions.

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Disclaimer: Information herein was obtained from sources which Mr. Long believes reliable, but he does not guarantee its accuracy. None of the information, advertisements, website links, or any ...

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