SEC Points Fingers, and Some Fingers Are Going Up….


The Securities and Exchange Commission (SEC) leaked it’s investigation of the May 6 flash crash.  While the investigation isn’t out, the leaks are pointing to one trade made at the Chicago Mercantile Exchange ($CME).  Waddell and Read ($WDR) placed a large order that tanked the market.  They continued to sell on the way down and on the way up.  Waddell says it was part of a “normal hedging strategy”.

It won’t end there.  CME will be on the hot seat for a long time now.  Virtually every sharp downturn in the market will be blamed on those pesky futures traders in Chicago.  NYC and Chicago have had an intense rivalry since 1972 when CME, CBOT, CBOE became the center of the currency, interest rate and option markets.  New Yorkers could never understand why they were traded in Chitown.

Back in 1987, the New York banking community needed a scapegoat for the crash.  They wanted to blame S+P 500 futures.  Those futures were started in 1982.  What they didn’t want to blame was the over all economic environment, or the fact the market got a little ahead of itself.  Anyone but them.

After an extensive investigation, more painful and invasive than a colonoscopy, the government found that CME’s S+P contract really had nothing to do with the crash.  As a matter of fact, the S+P took the selling pressure the specialists in NYC couldn’t handle.  The posts in NYC closed.  Chicago stayed open.

The ensuing FBI sting investigation of futures markets that occurred in 1988-1989 was a direct result of the 1987 crash.  By the way, the FBI found very little and it was a total waste of time and money.

An aside, if you wanted to see a trade register of all the trades done that day, and who traded with whom at what price, where could you get it?  As Jack Sandner, then chairman of CME likes to say, “We can give it to you the next day.”  In cash equity and option markets it’s a minimum of three days, and it’s likely to be many more than that.

CME knew instantaneously who’s orders those were in the S+P market on flash crash day because it was all done electronically.

High Frequency Traders (HFT) are about to get a rectal exam that they don’t want.  From the WSJ, “The SEC’s real focus now is on the market-making community, but more specifically the high-frequency trading community,” said one brokerage executive involved in the discussions. “Even though many are not registered broker-dealers or registered market makers, there’s a view that they probably should be, because they’re trading so much volume in particular names.”

In my business, I compete with HFT guys, so I hate them like the Oklahoma Sooners hate the Texas Longhorns.  But, it would be really hard to prove to me that HFT was the cause of the flash crash.  Are their modifications to HFT that I would make, practices I would ban?  You bet.

But in making those changes I would focus on the cash equity side of the market.  Why is their payment for order flow?  In microeconomic terms it is a subsidy.  When you have a subsidy, you get more of whatever you are subsidizing.  There should be no reason to subsidize liquidity.  You want to take risk and trade, do it.  You get paid if you are right.

I would end internalization of order flow.  Why do the juiciest orders never hit the market?  At CME we banned dual trading because so many order fillers were “internalizing” their order flow and reaping huge money off it.  Investment banks do this every day, all the time.  There is no reason for it.  Put the orders out there in a competitive marketplace.  There is little risk in trading against a lay up order.

Quote stuffing should be banned and any other nefarious practices that electronic trading enables.  In the old days of open outcry trading, bids and offers were subject to “immediate acceptance”.  This meant if I yelled, “Double Bid on  500!”  As soon as the sound of my voice stopped, the bid was dead.  If seconds later someone hit me and it would be up to me to take the trade or not.  It was also dependent on pit etiquette, and that person’s particular honor. Do that enough and no one will trade with you.

Computerized trading doesn’t have “honor” or any human factors associated with it.  Exchanges do need to take a look at how they put things like that into electronic environments.  Unfortunately it changes the responsibility game.   The peer pressure of a pit enforced a lot of the rules on its own.  In the new world, the exchange has to be like a cop and constantly patrol for firms violating rules.  Because every trader is looking for an edge, they will do things electronically that they would never do in a face to face environment.

Interestingly, we have had mini flash crashes ever since the big one in May.  Virtually every week, some stock has a massive sell off, with a corresponding bounce. Rarely does it affect the entire market, but Apple($AAPL) did on the open the other day.  A great question is have we always had mini crashes?  A PhD candidate can explore that question.  My expectation is that we didn’t, because specialists were designated to not let that happen.  In return for that market responsibility, specialists were allowed to dual trade.  They made a lot of money!

Like almost anything that comes out of Washington these days, I smell a rat.  In 2008, the DOJ leaked an internal memo that caused CME to drop 140 bucks in one day.  The SEC and DOJ delayed the merger of CME and CBOT, CME and NYMEX.  Back in 1999, when CME was preparing to go public, the IRS took over a year examining if it would be a tax free transaction or not.  When the bureaucrats get something, the sausage making machine starts to work.  No edict out of Washington comes through untainted by petty politics. Doesn’t matter who is running the show there, the game doesn’t change.

UPDATE

On cue, here is some data on today’s (10/1-10) flash crash from Zerohedge.com