The Ticking Time Bomb

Certainly, you remember many comics or television shows where they show a long fuse that is burning toward an eventual blow up. Or, hidden deep into some vault, there is a tinny tick, tick, ticking. That is the market today.

Knight Trading’s problems just bring that time bomb a little closer to the surface. Some will say that Knight was careless and should have tested their program in a parallel environment before they launched it. It begs the question, how many programs are launched that aren’t tested? How many times has this been done before with no market repercussions?

The market dislocations are becoming all too common since the Flash Crash exposed the weakness of our current market structure. The SEC blamed that occurrence on a one order fat finger and instituted circuit breakers to try and stop it from happening again. Are you sleeping better knowing the SEC has your back? Ask Bernie Madoff investors how that goes.

If you follow people like Themis Trading, daily they can show you a flash crash in a particular stock or ETF. Daily. In futures markets, we see it happen every week in some market somewhere. The only good news about the futures market is that there are daily limits where the market cannot possibly trade through. But when a future jumps in price within a millisecond, it changes the dynamic of the underlying market and makes hedgers wonder if there is safety there or not.

Unfortunately, these kinds of gyrations combined with all the other uncertainty in finance has caused the average investor to pull out of the market. It’s also affecting the high end of the market, as experienced and well heeled investors do the same. Losing confidence in the viability and fairness of the broader markets chip away at the foundation that America was built upon.

Cynicism isn’t a strategy to build wealth. Creeping cynicism by virtue of the crony capitalism in our governments, and the crony capitalism that is codified in our market structure is undermining the true reason that markets exist. To allocate resources efficiently and build wealth.

People may delight in the lofty number posted by the S+P($SPY, $ES_F) and take comfort in it. “We are back”, they say. Market pros from both sides of the political aisle look at that number, look at economic growth, look at corporate investment, and look at Federal Reserve policy and know full well how that number was posted. Sugar highs aren’t lasting.

Computerization by itself isn’t bad. It’s the market structure that stinks. Internalization, payment for order flow, multi-tiered distribution systems, dark pools of liquidity, quote stuffing, phantom orders are all anti-competitive ways for the big boys to avoid risk and make money.

What happens when the next time bomb explodes? The bombs are in there, ticking……

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for more on this, read part 2

Thanks for the link Instapundit
tip of the hat to The Daily Crux
Thanks for the link Abnormal Returns

22 thoughts on “The Ticking Time Bomb

  1. Do you think the huge loss that Knight took will be an incentive to be more careful and to cut back on the speed of these trades?Or should regulators get involved by charging a penny per transaction which will dampen not only these types of trades but the market in general?

    1. I do not think they actually took that huge loss that is being reported, as a lot of the trades that were done on that day have been unwound. I

        1. Speed might not be the problem, but it could be an avenue towards a solution. As others have proposed, slowing permissible trading speed to one trade every 2 seconds and either putting a penny tax on transactions or forcing, say, every hundredth trade to settle, would go a long way toward adding back in a certain degree of stability.

          1. I am against any and all taxes. I think if you make every order hit a public order book, and correct market structure, a lot of the HFT problems would solve themselves. Then we would need to police the order types, quote stuffing etc.

  2. According to the SEC The flash crash was not triggered by a “Fat Finger” trade, which is a trade made in error, but by a single large deliberate trade. I think this actually strengthens your point.

    1. I have heard both. No one deliberately enters an order like that. Plus, based on restrictions, you can’t. There is a limit to order size entered into a futures market.

  3. For a contrary opinion, with which I agree, see the recent articles on Kid Dynamite’s blog such as this one:
    In brief, for a buy-and-hold investor, flash crashes should be completely irrelevant. For a small day trader, “algos gone wild” provide an opportunity to profit at the expense of HFT firms’ trading errors. For HFT firms, if they are not protected from their own mistakes by the unwinding of “mistaken” trades, the free market provides a powerful incentive to get the trading algorithms right.
    We do not need more regulations to “solve” a problem that exists only in the minds those who want to be protected from the consequences of their own mistakes or ignorance.

    1. I agree, we don’t need more regulations. We do need a level playing field and correct regulation. Is the Kid a fan of payment for order flow or internalization?

  4. We don’t need more regs, we just need ONE, which to my mind makes a lot of sense, and restores the purpose for which futures markets were developed:
    When you buy commodities on a futures contract, you must take PHYSICAL DELIVERY of the commodities you buy.

    1. you are an idiot. Clealy you have no clue about the futures markets and why they exist. Not everyone who buys a Corn contract has any use for the corn behind the contract, but there is still a legitimate use for the hedging of Corn which is a factor in the business they run.

      “Better to keep your mouth closed and be thought a fool than to open it and remove all doubt”

    2. Some products are better off without physical delivery. Eurodollars for example. The industry ought to set the standard for delivery. For example, in crude oil they want “wet barrels”. Of course, the other thing you are saying is let’s end all speculation and that is not a serious idea. Speculation doesn’t increase price, but lack of speculation will increase risks and increase price volatility. Look at the price of onions vs oil.

  5. About 30,000 people are killed every year in car crashes in the US. I’ve seen estimates as high as $230B for the cost of car crashes every year. Yet, we somehow keep using this complex technology (which, btw, is now high frequency. My stability system samples over 100 times per second to compute adjustments based on how I’m driving, and is definitely a software program that’s subject to bugs and unforeseen edge cases). So it is with computerized trading. We use it because it saves so much money, just like cars do, but with a lot less fatalities (not counting Knight). Relax, it’s not as bad as the scare mongers want you to think. No doubt, we’re going to go through a period of adjustment, discovering all kinds of ways that things can go wrong, just like we do in cars, or airplanes, or electricity, or any other complex, dangerous technology introduced by humans. The efforts to speed this adjustment process need to be aligned with reality, not driven by self-interested parties yelling “Fire!” in crowded theatres. Believe it or not, some of the loudest objectors to hft have businesses that have been damaged by it, because it has surpassed their older technology and undercut their cost structure. I’m sure that they truly are only interested in the commonweal, but I would take their advice with a grain of salt. I’m reminded of the buggy whip makers who warned that cars are dangerous and scare the horses. It sucks to be inside the sausage factory, but it’s where we are, and the sooner we stabilize the system, the better. Bandaid solutions proposed by those who know almost nothing about the reality of HFT are destined to make things much worse and much, much more costly to the average investor.

    1. Advocates of elec trading always bring out the buggy whips. I am not against elec. trding. I abhor the current market structure. It’s anti-competitive. Additionally, the elec trding community needs to police its own against all the abuses taking place-front running, quote stuffing etc, and I don’t see any geeks stepping up to the plate to do that. I also think that in many marketplaces, we need to re-engineer how electronic trading interfaces with them to make it better. But, until we get rid of dark pools, internalization, pay for order flow, tiered distribution, etc we are going to see more and more of this kind of thing.

      1. I agree. It’s about ethics – not technology. The Madoff syndrome. Technology in the wrong hands has huge social repercussions. I would prefer to believe these irregularities are purely a result of human error (!) and due to not scammy attitudes. Well, if – and it’s a mighty big IF – those who make an expensive blunder willingly take it on the chin and compensate us for all the damage they do, I’m OK with that. I fear that is a ciustom more honoured in the breach than in the observance.

    1. One day sounds too long. It would not allow legit human traders to react to real events. Most of these computer trading shenigans are done in milliseconds, so why not just have a mimimum holding period of 10 minutes. That still allows humans to react intelligently to real events, but slows things down enough that humans can also react to the computer trades.

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