Apparently the market is very unstable.
This is the message regulators are unwittingly sending with news yesterday that UK futures trader Navinder Singh Sarao working from home in West London has been arrested for precipitating an epochal US stock-market crash.
On May 6, 2010, the global economy wore a lugubrious face. The Greeks had just turned their pockets out and said, “We’re bollocks, mate.” (Thankfully, that problem has gone away. Oh. Wait.) The Euro was on a steep approach with the earth. Securities markets were like a kindergarten class after two hours without some electronic amusement device.
By afternoon that day, major measures were off 2% and traders were in a growing state of unease. The Wall Street Journal’s Scott Patterson writing reflectively in June 2012, interviewed Dave Cummings, founder of seminal high-frequency firm TradeBot. Heavy volume was scrambling trading systems, Patterson wrote, leading to disparities in prices quoted on various exchanges. The decline became so sharp, Cummings told Patterson, that he worried it wasn’t going to right itself. If the data was bad, TradeBot would be spreading contagion like a virus.
Ah, but wait. Regulators now say mass global algorithmic pandemonium May 6, 2010 was just reaction to layered stock-futures spoofing out of Hounslow, a London borough featuring Osterly Park, Kew Bridge and a big Sikh community. If you think the Commodity Futures Trading Commission’s revelry over finding the cause of the Flash Crash just north of the Thames and west of Wimbledon stretches the bounds of credulity, you should.
Mr. Sarao is accused of plying “dynamic layering” in e-mini S&P 500 futures, a derivatives contract traded electronically representing a percentage of a standard futures contract. It’s called an ideal beginner’s derivative because it’s highly liquid, trades around the clock at the Chicago Mercantile Exchange, and offers attractive economics.
Should we be comforted that regulators believe one guy trading from his house in an abundant and globally available starter contract took out 10% of market-capitalization in US stocks for 20 minutes? They’ve either gone daft or think us dimmer than we hope.
Authorities say Mr. Sarao entered gobs of sell orders at variable prices inflating supply, and then canceled the trades without executing them. This is called spoofing in regulatory parlance (a spoof is a joke but not to the magistrates). You can’t do that purposefully we’re led to believe.
One of the most popular trading order types is the IOC – Immediate or Cancel. IOCs permit traders to hit part of an order and instantly dismiss the rest. It’s legal. Apparently it’s only illegal if you cancel the whole thing to fool people.
I can’t speak to the merits of mens rea (intent) or evidence in Mr. Sarao’s case. But the entire construction of the equity market and increasingly other markets too is deception. Hiding shares instead of displaying them is sleight of hand to avoid gaming. Institutions routinely take large orders that would otherwise be elephants in markets and atomize them so as to in effect tiptoe them across a proverbial putting green.
Meanwhile fast traders are continuously pinging markets for atomized trades that in a models look like somebody trying to tiptoe an elephant across a putting green.
When Accenture traded to a penny on May 6, 2010, it happened because every single order to buy between about $41 and zero save the bid farthest from the offer, at $0.01, disappeared. What got hit and filled was a buy at one cent. The problem wasn’t illusory liquidity but elusive buyers.
Regulators subsequently eliminated so-called penny “stub quotes” that don’t want to buy or sell. There’s the problem, not a dodgy Londoner’s finger. The market is built around the best price and automated quotes that combine to create a glowing electrified grid of prices set by traders hoping not to own stuff. The moment an order leaves – a bulb burns out – a cascade can ensue because they’re all in a sense chained, and the grid blinks out.
Spoofing aside, what impresses about the market today is its resilience. It’s not really unstable. Some guy in a British basement betting on derivatives is not the bane of our existence – and telling the world so will not improve public confidence. No, despite a global construct run by machines with billions of messages and millions of trades and trillions of dollars daily, almost nothing goes wrong.
But the market is a data network run by machines. Sooner or later data networks fail. Rather than chasing spoofers as cure for crashes, regulatory time would be better spent pondering whether the global investment market should be one giant data network run by machines.