We co-wrote a white paper with investor R.T Leuchtkafer, What’s Changed Since The Flash Crash, over two years ago, and thought it would be useful to read it again, specifically as it references the CFTC-SEC Advisory Commission on Emerging Regulatory Issues and their 14 recommendations in the aftermath of May 6th 2010.
Those CFTC-SEC 14 recommendations were:
1) Implement single stock circuit breakers (SSCBs) and clearly erroneous rules.
2) Expand SSCBs to all listed securities including options.
3) Implement LULD mechanism.
4) Evaluate whether pauses longer than 5 seconds make sense.
5) Create new system-wide circuit breaker rules for the market.
6) Ban naked access HFT; create testing for BD risk management controls.
7) DCM-FCM Disruptive Trading Practice Monitoring for Large Orders
8) Examine Maker Taker – increase HFT incentives on stressed days.
9) Examine creating new market maker incentives for “reasonably related to the market” quoting.
10) Explore implementation of a uniform cancellation tax for HFTs.
11) Regulate internalizing firms so that they provide 50mil price improvement, and so that they always must execute a meaningful portion of internalized orders.
12) Adopt a Trade-At rule, and expand NBBO protection to DEPTH OF BOOK.
13) Require uniform dark pool reporting.
14) Urgently implement a consolidated audit trail (CAT)
Of those 14 recommendations, the top half have been addressed – the low-hanging fruit. The bottom half – the meaty ones – sit accumulating dust.
Maker-Taker remains unexamined. We imagine this is the case because the regulators are in fear of the stock exchanges going out of business. The situations that they have placed themselves – focusing on a business model of becoming server farms – has backfired for them and the regulators fear that has reached a point of no return.
HFT’s still have no meaningful obligations. They can short as easily as they can buy. Their capital is not commensurate with the potential for damage that they can inflict, and incur themselves.
A cancellation tax has been discussed but nothing has been even close to being proposed by our regulators. We suppose that an HFT industry, that has become less profitable in a hollowed out markets structure they created, still has the ear of our regulators. And so the increased technological burden that we all share still unfairly favors those firms that stress the system and cause the harm.
There has been no talk about regulating internalizing films, or of expanding NBBO to depth of book. That talk would be meaningless anyway, as REG NMS’s 1 second exception for protecting quotes renders the whole premise of quote protection laughable. On the contrary, there has been talk in Washington about allowing locked markets, and abandoning quote protection.
There is no trade-at rule, or anything close to resembling dark pool regulation, despite the SEC first proposing such reforms in autumn 2009. Even recently, three of the four exchange families (NYSE, NASDAQ, and BATS) traveled to the SEC to urge them along on a trade-at rule. Direct Edge was not with them – possibly because it is owned meaningfully by firms who would not want such regulation.
There are no uniform dark pool reporting or disclosure requirements, still.
The CAT is years away from being built, implemented, and being a useful real-time surveillance tool.
Where do we stand today, May 6th 2013 – three years later?
- Mini-flash Crashes occur daily, despite SSCB’s and despite LULD.
- Internalizers – who buy investor orders so that they may be siphoned off of, as well as financially modeled, do more volume than ever. Off-exchange trading frequently exceeds 40% of trading volume.
- Proliferation of news and social media-reading HFTs, enabled and encouraged by data feeds sold to them by news organizations and stock exchanges, are in their infancy and rising in number as well as trading volume.
- The “race conditions” created by a distortive maker-taker pricing mechanism still exist, which discourages diverse participation in limit order books – a prerequisite for safe markets.
- The CFTC-SEC’s 18-word truism, “even in the absence of extraordinary market events, limit order books can quickly empty and prices can crash” remains the case today.
- The CAT that the regulators so urgently stressed as vital in the Flash Crash’s aftermath remains a distant mirage – years away from bidding, selection, and implementation.
Can a Flash Crash happen again?
Yes. Marcos Lopez de Prado, the head of high frequency futures trading at Tudor Investments, said it quite elegantly:
“Flash crashes are happening all the time.[…] It’s just that they don’t reach the magnitude of May 6. High frequency market makers in particular run with very limited capital. They’re not like the traditional market maker that would operate with large capital and little leverage and they could just withstand a position for several days. Once they face a loss of one or two percent, they have to liquidate and protect their firm. In these circumstances we’re seeing many more mini flash crashes.”
The backbone of “liquidity provision” in our non-diverse limit order books are undercapitalized, engaging in race conditions, and operating with no obligations in any kinds of stress. What appears to be a well-functioning market structure in a diminished volume, low volatility, and complacent environment has the potential – in fact the likelihood – to self-destruct in times of stress.
Let us quote from our paper from 2011.
“Our markets will continue to remain vulnerable as long as we as an industry remain in denial of the fact that volume does not equal liquidity, and as long as we tolerate the for-profit exchange model, which places its revenues from encouraging speed above all other concerns and safety.”
It is increasingly obvious to any market observer that our industry and our regulators will continue to stall and ignore the cores issues and problems until we have another substantially damaging market event. Make no mistake; we are all thrilled that the market has made new highs, fueled by QE and improving economic conditions. However it is precisely now that we should be fixing the plumbing and conflicts underneath the thin crust of liquidity, so that when inevitably stress does return we are tooled to deal with it from a market structure perspective.