A Look Back at the Flash Crash

By Jonathan Yates

In the year after the “Flash Crash,” the response of professional investors has been like that towards growing crowds at your favorite restaurant. You want enough customers to eat there to keep it in business, but not so many that you have to wait for a table. While the increased profits, greater liquidity, rising affluence of the exchanges, more influence with regulatory bodies and other benefits brought to the stock market by High Frequency Traders are much appreciated, events like the “Flash Crash” which could result in adverse changes for all financial exchanges are most certainly not welcome.

Maintaining an “orderly market” has always been the primary, articulated goal of any financial exchange. In order for investors to have the needed confidence to buy securities, the exchanges have to be, to a degree, predictable or at least comprehendible. At a speech last year at the World Federation of Exchanges, Thomas Peterffy, Chief Executive Officer (CEO) of Interactive Brokers cautioned that, “It’s not so much anymore that the public does not trust their brokers. They do not trust the markets, the exchanges or the regulators either. And why should they, given our showing in the past few years.” The year since the “Flash Crash” last May 6 has done nothing to change this sentiment.

Wall Street has always benefitted greatly with the huge majority of its profits derived from being “The House.” Protectionist legislation such as Glass Steagal allowed for huge investment banking fees to be garnered and massive bonuses paid. Fixed commission rates guaranteed profits. Lengthy periods for marking trades and then clearing and settling them along with access to the book of customer orders have generated huge profits. Selling order flow is also highly lucrative. Again, from Peterffy’s speech:

The root of the problem, as always, is short-sighted greed on the part of the brokers. Transparent commissions are not enough for them. They want to take more from their customers but without the customers seeing exactly what it is that they are paying. This is done by what is called internalization, which is easiest to illustrate with OTC products. The banks simply take the opposite side of the customers’ orders at prices that leave the banks with undisclosed but huge profits.

How do we know that the profits are huge? Just look at the banks’ quarterly financial reports on derivatives dealings. Even the more modest estimates exceed $100 billion per year, worldwide. Customers are on the other side of those trades. Customer losses are on the other side of those bank profits. The amazing thing is that those banks are able to convince their customers that this is good for them and moving these contracts on to the exchanges would harm the customers.

As a result of these changes, the major institutions (“Internalizers” or OTC market makers) are now the most valued customers for brokerage houses, not individuals anymore. According to the Rule 606 reports mandated by the U.S. Securities and Exchange Commission, no major online broker, with the sole exception of Interactive Brokers, sent more than 5% of its orders to an organized exchange. More than 95% of their orders go to internalizers. As an example, for the second quarter of 2010 Ameritrade sold 83 percent of its market orders to Citadel.

According to research from Dr. Xiavier Giang, Professor of Finance at New York University and an expert in major fluctuations in stock markets, a significant downturn of at least 10 percent will transpire every 13 years, on average, for an exchange. This happens for all, whether domestic or foreign, as major institutions come to dominate the financial markets due to the potential for profit and their superior resources, according to his paper, “Institutional Investors and Stock Market Volatility.”

As the major institutions move in unison, there will come a time when a confluence of events will precipitate massive selling. Market makers are then dominated by the technology and resources of institutional investors: maintaining an orderly market becomes impossible. The cascading of orders will overwhelm any circuit breakers or stop trade mechanisms in place. Those that do work will be negated by the trades being placed a day or two later by institutional investors. Even the shutting down of exchanges is of little good: on Monday September 17, 2001, the Dow Jones Average still fell 638 points despite being closed for several days after 9/11.

In the year since the Flash Crash, little of any meaningful consequence has been implemented that will prevent another. Some, but not all stocks have trading halted if they fall more than ten percent in a short period. This year is on course to register about 2000 trades where a stock will rise or fall more than one percent in a second and then recover. Last year, there were 1818 and in 2009 there were 2,715. Many erroneous trades are not even detected as there is only a one hour period for reporting. “Nothing has changed,” says Eric Hunsader of Nanex, a firm that collects market and trading data. “The complacency has made it worse.”

Despite coming under the dominion of institutional investors, more individuals are being forced towards financial markets for their needs such as retirement planning and saving for college. Traditional pensions, defined benefit programs, are being replaced by defined compensation arrangements such as a 401k. The low interest rate environment being maintained by the Federal Reserve rewards investors, who can borrow cheaply to leverage up for acquisitions or trading financial instruments, and penalizes savers, who are faced with anemic yields for certificates of deposits and savings accounts. Bill Gross, co founder of Pacific Investment Company (PIMCO) expects this situation to prevail for another 15 years.

While the great bulk of trading is done by institutional investors, it is the individuals who finance the mutual funds and pension funds with their 401K contributions and 529 college savings plans. If enough individuals turn against the financial markets due to a lack of confidence, the exchanges will eventually collapse from their own mass. Financial exchanges, like any marketplace, must attract retail customers in one form or another if they hope to endure in relevance. If major institutions trading with major institutions were the ideal financial exchange, then the market for credit default swaps would have been the last to implode rather than first in The Great Recession. Should High Frequency Traders continue to dominate the exchanges, then the retail base of customers needed for any market to survive will eventually be lost.