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Protect Yourself from the Next Stock Market "Flash Crash

Stock-Markets / Financial Crash May 19, 2010 - 05:12 AM GMT

By: Money_Morning

Stock-Markets

Best Financial Markets Analysis ArticleShah Gilani writes: Just when you thought it was safe to get back into U.S. stocks, you think you see a shark.

If you are searching - like the regulatory lifeguards and all the political beach bums - to pinpoint and kill the menacing shark that took a huge bite out of investor confidence when the Dow Jones Industrial Average tanked 1,000 points in a just a few minutes late in the day on May 6, don't bother to scan the horizon looking for the dorsal fin of some lurking predator.


The threat you fear isn't under the water: It is the water.

We're talking about market liquidity.

Investors who wish to understand the cause of the stock market flash crash must first understand the nuances of stock-market liquidity. For purposes of this discussion, we'll define liquidity as "an asset's ability to be sold without causing a significant movement in its price and with minimum loss of value." In other words, that liquidity is the fluid that floats fair and orderly markets.

Unfortunately, market liquidity has been evaporating under the heat of trading venue competition.

That's one key reason that investors should be scared about being in the markets. But it's not the only one. To understand the potential current market pitfalls - and the steps investors can take to avoid them - we're going to take a look at:

•The truth about what caused the flash crash.
•What should - but won't be - done in response.
•And what you need to know to protect your portfolio.
Let's start by rounding up all the usual suspects - the high-frequency traders, the hedge funds, the prop-trading desks, the derivatives traders, Goldman Sachs Group Inc. (NYSE: GS), the U.S. Federal Reserve, and Satan - even though that's an exercise that won't yield any confessions or get you any closer to the truth.

Maybe one of them lit the fuse; maybe all of them - collectively - are to blame. Although it's good sport - and not necessarily wrong - to point fingers at any of these market movers, doing so misses the underlying fact that the problem investors face is systemic.

The factors that led to the stock market flash crash are actually the unintended consequences that can result when you promote competition.

(Un) Making a Market
Back in 1975, the cozy world of fixed commissions on stock trades ended forever. The resultant competitive push to execute trades at increasingly reduced costs eventually morphed into the never-stand-pat world of computerized trading, and what were once fair-and-orderly markets devolved into chaos.

In the quaint old world of Wall Street, which revolved around the New York Stock Exchange (which is actually on Broad Street), brokers funneled all their customers' orders to buy and sell stocks to "the Exchange.'

At the NYSE (NYSE: NYX), later known as "The Big Board," all the orders went to a "specialist" whose job was (and still is) to keep a "fair and orderly market" while executing all the trades in the stocks for which he is the specialist. To make sure he had a record of all "Buy" and "Sell" orders, he wrote them down in a big leather book.

The "book" had the names of the brokers (only brokers can send orders to the Exchange) who sent down orders along with the number of shares and the prices at which customers wanted to buy and sell the stock. The specialist was responsible for keeping the book and making a market, meaning showing the public what the "bid" was (the highest price someone was willing to pay) and how much stock was being bid for, and what the "offer" was (the lowest price someone was willing to sell at) and how much stock was being offered at that price. The process is called "keeping a book," or "making a market."

When a buyer wants to pay the price a seller is offering to sell at, or when a seller wants to sell at a price a buyer is willing to pay, a trade occurs. That trade is then transmitted to the "tape" (which used to be a long running, thin ticker tape but is now electronically transmitted) to be displayed for the entire world to see.

What's important about the old system is that there was only one specialist per one stock and all orders to buy and sell that stock went into his book. The book was said to be "deep" if there were lots of standing orders waiting to be executed when customers' price objectives were met.

Besides matching "Buy" and "Sell" orders, the specialist can trade the stock for himself. In fact, if there aren't enough public orders to keep the stock trading in an orderly fashion, the specialist is required to trade the stock (make bids and offers) to keep a "fair and orderly market" - regardless of whether the stock is headed up or down, and regardless of how fast it's moving.

From One to Many
Then along came the competition. Other exchanges began to spring up to trade new stocks that were being offered to the public. The American Stock Exchange (AMEX), the Boston, the Philadelphia, the Pacific and others sprang up. Then the electronic age yielded the NASDAQ (National Association of Securities Dealers Automated Quotations), where there wasn't a single specialist in charge of any one stock, but several "market-makers" - each of them acting like mini-specialists, and each making a market in the same stocks.

After fixed commissions were done away with in 1975 and greater competition was encouraged, it was only a matter of time and innovation before new trading facilities sprang up. However, these newcomers didn't want to trade new stocks, they wanted to trade the same stocks that were once the exclusive provinces of the physical exchanges - the NYSE, the AMEX and the Nasdaq. And these newcomers wanted customers to be able to place orders directly, bypassing brokers altogether.

Now we've got physical and electronic exchanges trading each others' stocks, "upstairs" block trading desks, private crossing networks (Instinet, the original "private" exchange established in 1969), electronic communications networks (ECNs) that allow direct access to execute posted bids and offers, ECNs such as BATS Global Markets that have become their own exchange, internal broker-dealer matching facilities, and what's infamously known as "dark pools," where big mucky-muck dealers like Credit Suisse Group AG (NYSE ADR: CS), Goldman Sachs and Knight Capital Group (Nasdaq: NITE) cater to institutional behemoths who don't want to mix their sizeable orders with the little people.

Anatomy of a Downdraft
When it comes to the stock market flash crash, the bottom line is that the new "system" has too many moving parts and no funnel to facilitate a singular, deep "book" of orders to ensure a fair and orderly market.

Precisely because there are so many competitive trading venues, orders are actually split up for reasons that include:

•Blind execution (not wanting anyone to know who is trading how much of what).
•Payment for order flow (getting paid to send orders down to different exchanges or venues to create liquidity because they don't have enough).
•And, of course, because of the costs, cronyism, and the clout that comes with extravagantly entertaining clients to get them to trade through self-serving systems.
The professionals aren't stupid. They know that markets aren't deep, so they don't put down big orders. In just the past few years, the average NYSE trade has dropped from 1,600 shares to about 300 shares per trade. According to Tabb Group, a New York consultancy, 10%-12% of stock trading volume is executed (and not counted) on some 40 dark pools.

It doesn't matter if a fat-fingered mistake sent a giant order down to an exchange by mistake, or if a big options order caused some index to tank, or that panic over Greece sent stocks lower and the NYSE had circuit breakers that other exchanges didn't have. Nor will it matter if new rules make other exchanges incorporate all the same "liquidity replenishment points" (or circuit breakers) that the Big Board uses.

Liquidity evaporated on the NYSE and trades rolled over to other exchanges, and guess what? Because there was panic all around, bids evaporated as traders cancelled them, there is no depth in any venue's "book" for any stock, and the liquidity that high-frequency traders are supposed to provide (their HFT arbitrage and algorithmic trading models generate anywhere from 50% to 70% of daily trading volume, which absolutely helps create liquidity in normally functioning markets) evaporated as they shut down operations, afraid that their computers would blow them up with losses.

That's the truth.

It's a systemic problem that can't be easily solved because none of the players in the trading-venue business want to be disadvantaged by giving up any edge they have or are seeking to profit by.

Solutions and Caveats
If the investing public were to fully understand just how "thin" these markets actually are - and how 'at-risk their orders are - they are going to remain on the sidelines and the markets will be even more dangerous for all of us who are in them with our pension money, IRAs, mutual funds, or other hopes we have for a reasonable return on our equity investments.

What's worse is that we desperately need those robust returns from stocks in order to offset the piddling interest payments that we'll receive on our fixed-income investments, thanks to the too-big-to-fail bankers who busted the economy so badly the Fed has to have a zero-interest-rate policy so the same bankers can rebuild their balance sheets and bonus pools by re-leveraging themselves on taxpayers' backs.

The only fix is to make all venues post all their bids and offers into a central "book" to provide necessary depth and liquidity to make markets fair and orderly again. There are ways to identify whose orders are adding to liquidity, ways to compensate orders differently, and ways to keep the system both blind enough and transparent enough for everyone to be safe. But, as usual, the greed of the few (who have the political muscle and money) will have to be throttled to make the track safe for all investors to get to the finish line.

Until that happens, ask for written "best practices" from your brokerage or trading venue on how they execute trades. Demand to know what circuit breakers, failsafes and other protective measures are in place to protect you. Ask about what happened to market orders they executed during the flash crash: Did they get cancelled outright, or were they erroneously executed as a result of that late-day nosedive? And lastly, if disputes arose, how were they settled?

The bottom line: Find out what rights you have, and get those guarantees in writing.

[Editor's Note: Shah Gilani, a retired hedge-fund manager and renowned financial-crisis expert, walks the walk. In a recent Money Morning exposé, Gilani warned that high-frequency traders (HFT) were artificially pumping up market-volume numbers, meaning stocks were extremely susceptible to a downdraft.

When the May 6 downdraft came, Gilani was ready - and so were subscribers to his new advisory service: The Capital Wave Forecast. As of Friday morning, because of that market move, investors were up 186% on a short-term euro play, and more than 300% on a call-option play on the VIX volatility index.

Gilani shows investors the monster "capital waves" now forming, will demonstrate how to profit from every one, and will make sure to highlight the market pitfalls that all too often sweep investors away.

Take a moment to check out Gilani's capital-wave-investing strategy - and the profit opportunities that he's watching as a result. And take a look at some of his most-recent essays, which are available free of charge. To read one of his most-popular essays, please click here.]

Source : http://moneymorning.com/2010/05/19/flash-crash-3/

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