High-Frequency Trading Could Cause Another Flash Crash

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The threat of another flash crash caused by high-frequency trading is as great as ever.

And the next flash crash could be much worse than the one that shocked investors in May 2010.

Although the Securities and Exchange Commission (SEC) has taken some steps to prevent another flash crash caused by high-frequency trading (HFT), some experts question whether the additional disclosure and "circuit-breakers" designed to prevent big, sudden price moves will make a difference.

"Those things won't prevent another flash crash - they can't," said Money Morning Capital Waves Strategist Shah Gilani. "All they will do is soften the move."

The real issue, Gilani said, lies with the computers that execute the trades - thousands of them in milliseconds.

HFT has changed the nature of the stock market since these trades now account for between 60% and 70% of the transactions on the U.S. stock exchanges.

"You can't stop a flash crash unless you stop the computers from doing what they're programmed to do. And that's not being addressed," Gilani said. "The SEC is looking at keeping the ship from sinking, not stopping it from hitting icebergs."

HFT's heavy volume and high speed made it the prime suspect in the flash crash of 2010, when the Dow Jones Industrial Average plunged more than 600 points in five minutes, before recovering almost as quickly.

Mini Flash Crashes

Since then, the frequent occurrence of mini flash crashes - when a single stock or exchange-traded fund experiences a steep and rapid drop in price that quickly reverses - have served as nagging reminders of the vulnerability of the system to such events.

"It's like seeing cracks in a dam," James J. Angel, professor at the McDonough School of Business atGeorgetown University told The New York Times. "One day, I don't know when, there will be another earthquake."

Studies of HFT and the 2010 flash crash have supported the idea that the markets are still vulnerable.

A study commissioned by Barron's applied the new SEC circuit-breaker rules to trading data from the 2008-2010 period with troubling results.

Had the current trading limits been in place during the 2010 flash crash, only 14% of stocks in the Russell 1000 would have been affected.

Although not proof the circuit-breaker rules would fail, the study did show the need for more back testing of the new rules.

"While I understand the pressure to "do something' in the wake of the flash crash, it is disconcerting that no one has done this sort of back testing in advance of policy decisions," Casey King told Barron's. King, director of the Yale School of Public Health's Center for Analytical Sciences and a former Salomon Brothers employee, conducted the study.

A second study, conducted by the U.K. Department for Business, Innovation, and Skills, concluded that the computerized complexity that made the flash crash possible in 2010 make it just as likely to happen again.

And the next time could be worse.

"The true nightmare scenario would have been if the crash's 600-point down-spike, the trillion-dollar write-off, had occurred immediately before the market close," the U.K study notes. "The only reason that this sequence of events was not triggered was down to mere lucky timing the world's financial system dodged a bullet."

High-Frequency Trading Vampires

Adding to the concern is that only 2% of the 20,000 brokerages account for all that high-frequency trading, and they bet big money doing it. In 2008 alone, Citadel Investment made $1 billion in profits from its HFT operations.

HFT critics claim these firms simply suck money out of the market.

Many HFT transactions are made solely to "sniff out" the market for demand and are withdrawn as quickly as they are initiated. That's what gives many HFT firms their lucrative edge.

In fact, as many as 95% of HFT trades are cancelled, undermining the argument that HFT adds liquidity to the market.

Experts say the SEC needs to go much further to have any hope of eliminating the threats that high-frequency trading poses.

Gilani suggested the SEC implement filters in the HFT traffic to the exchanges that would slow down opening transactions but not closing transactions. That would help "close the loop that remains open in fast-moving markets when new positions are entered, sometimes to knock down prices to facilitate the vacuum that results in bids evaporating and prices collapsing."

Money Morning Global Investing Strategist Martin Hutchinson offered two other solutions.

First, the SEC could introduce a rule that all orders must be exposed for a full second. That will reduce the volume of high-frequency trading, but still wouldn't truly protect non-computerized outsiders.

The second idea would be to introduce a small "Tobin tax" on all share transactions. It could be tiny; maybe 0.01%. (The SEC would also need to ban "exchange rebates" to traders).

"Such a tax would make the worst HFT types unprofitable, without imposing significant costs on retail investors," Hutchinson said. "It's about time the governmentimposed some taxes to stop the worst of these scams and recover the public some of its money."

But until the SEC implements stricter measures, high-frequency trading will keep the markets susceptible to trading excesses as well as another flash crash.

"We had a lot of change, we had a lot of money, we had no transparency, and it almost destroyed the financial system of the world," former Sen. Ted Kaufman, D-DE, an outspoken critic of HFT, told the Baltimore Sun. "I cannot stress enough how worried I am, how concerned I am about what's happening to our markets."

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