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

Himmelberg highlighted the growing market share of HFT and algorithmic trading across all markets and warned that the growing lack of traditional, human market-makers has made the market increasingly fragile.

He is, of course, correct as active traders will attest, if nothing else then by the 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 as shown in the schematic below.

As we discussed in greater detail back in April, the relentless, and increasingly commoditized ascent of HFTs, as well as the change to market structure and topology in a post-Reg NMS world, prompted Himmelberg to conclude that we live in a world where the biggest threat is not market leverage, but periods of sudden, unexpected and acute losses of liquidity. Or, as he put it, “liquidity is the new leverage.” This is how he explained it:

That analogy is meant to invoke the potential unrecognized problems or imbalances that build up over the course of long expansions. 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. I therefore see a risk that markets are paying too little attention to liquidity risk, much as they previously paid too little attention to the risks posed by excess leverage.

Furthermore, the fact that for the past decade global capital markets and risk assets have been constantly prodded higher courtesy of central bank liquidity injections, has exposed them to increasing instability not only at the micro level but at the macro: while virtually all HFTs – and roughly a third of all active asset managers (who were simply too young during the global financial crisis) have never encountered a market crash, the big test will be what happens, and how the market would react during the next crisis in which there is no “big picture” central bank intervention, to make “buying the dip” at the micro, HFT level, the correct response, even though so far aggressively purchasing the “crash” has been the correct response every single time…

… as volatility always inevitably tumbled, making selling vol one of the preferred “carry” strategies for numerous investors classes (ultimately leading to the historic VIX explosion of February 5 which blew up several of the most popular retail vol-selling strategies such as inverse VIX ETNs in a matter of minutes).

But what happens if one day the market crashes, HFTs, quants, algos, CTAs and various other program traders pile on by selling or merely shorting into the plunge and the market does not rebound?

That was the main concern voiced by Brian Levine, Goldman’s co-head of Global Equities Trading, who back in June in an internal Goldman interview said that while most facets of the current marketplace are not new per se, there is one aspect of that the current broken market structure that does keep him up at night. As he admits in the interview, “what’s more worrisome to me is a real flash crash, which I define as a situation when the market “breaks.”

Indeed, the market breaking is surely high on the list of every trader’s worst nightmares, and reminds us of what we predicted several years ago, namely that when the “big one” finally hits for whatever reason, there won’t be a 20%, 30%, 40% or more drop in seconds. The market will simply be halted indefinitely (see “How the market is like SYNC which was halted indefinitely”).

This is how Levine described his trading nightmare, the one in which the crash is not a “flash” and the market simply breaks:

The data is wrong, everything trades at dislocated prices relative to the NBBO, and everyone—justifiably—widens their spreads. That happens almost every time there’s volatility, largely because message traffic increases dramatically. This is due to the fact that the opportunity set is greater and there’s no economic disincentive for sending messages to the market, so more electronic orders come in. This slows the system, widening spreads and generating price dislocations, which triggers even more orders and compounds the delays—a predicament that is only further exacerbated by the fragmentation of the equity markets. As this happens, stocks may trade outside of the NBBO briefly in millisecond or microsecond increments, constituting what I consider a genuine flash crash. All of this becomes a negative feedback loop that causes more volatility.

Interestingly, if you define a flash crash by the percentage of executions that took place outside the NBBO, one of the largest ones occurred in 2008 after the first TARP bill failed, according to internal analysis we did a few years ago. And the market didn’t snap back, with the SPX closing down 10% on the day and on its lows. I think that may have been why there wasn’t talk of a “flash crash” afterward, but clearly the market structurally failed pretty badly that daytoo. This suggests to me that, in a situation with actual bad news, the current US market structure may not be able to handle it, and there could be a downward spiral.

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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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