Speaking at a Washington conference yesterday, CFTC Chairman Gary Gensler hinted that brokers/institutional traders using algorithms might have to face new rules regarding size, style, and limits. He, of course, was alluding to the large E-Mini order on May 6^th.  In his estimation the order could not be handled because there weren’t parties willing to buy the order and hold it for any extended period of time. He states:

“Just as there is a difference in tennis or ping pong between the rally before the point and the point itself, in markets, there is a difference between a position going back and forth between market makers and a position actually being bought by a fundamental buyer who will hold it overnight.  Much of the volume on May 6 was just positions being moved back and forth over a matter of seconds between high-frequency traders and other market makers. This is what our economists refer to as “hot potato volume.” For the large trader’s order to actually be absorbed by the market, it had to find fundamental or opportunistic buyers who were willing to hold the position at least for more than a few seconds…The events of May 6 demonstrate that, in volatile markets, high trading volume is not necessarily a reliable indicator of market liquidity.” 

Chairman Gensler is acknowledging what we have said repeatedly: volume does not equal liquidity. Our marketplace has become addicted to “hot potato volume”; in fact, we have become hostage to it. Consultants, exchange-heads, and conflicted brokers repeatedly warn, every chance they get, that any wrist slapping, any regulation, any attempts to limit the profitability of HFT, will widen spreads and decrease volume! The focus should always have been, and should be today, on making our markets liquid. High volume is not the same thing.

Were HFT firms churning and playing “hot potato” to such an extreme extent, such that they were skewing volume statistics and unnecessarily (and harmfully) driving up volume? In the May 6th E-mini contract example, much has been made about the size of the trade.  While it may be true that this was a large trade, shouldn’t the market  have been able to absorb a 9% participation rate? In addition, let us dissect the 75,000 contract E-Mini sell order. Only 35,000 of those contracts were sold on the way down; the remaining 40,000 were sold in the rebounding tape. Also, of the 35,000 contracts sold in the down tape, only 18,000 of them were executed aggressively  and the remaining 17,000 contracts were executed passively (see footnote 14 on page 16 of the CFTC/SEC report).

Now, let’s be clear, the problem was not the order rather the problem was the “hot potato volume” that the HFT traders generated  that spilled over into the equity markets, specifically in ETF’s. The SEC report states: “From 2:41pm to 2:44pm on May 6th, HFT’s traded 140,000 E-Mini contracts or over 33% of the total trading volume, according to the CFTC/SEC report.” This implies that 424,000 contracts traded in this 4 minute period.  This frenetic pace of HFT trading is what caused the algorithm to execute its 9% of volume in 20 minutes.

This “hot potato” volume is also very similar to what is known as “circular trading”.  Circular trading is rampant in India and their regulators have been grappling with it for years.  Circular trades happen when a closely knit set of market participants, mainly brokers, buy and sell shares frequently among themselves to effect a security price. These trades do not represent a change in ownership of the security.  They are simply being passed back and forth to create the illusion of price movement and volume. “Hot potato” volume is not something that should be just overlooked as harmless since it is only HFT’s trading with each other. Their volume drives institutional decisions, albeit less so going forward, we hope. Most damaging though, is that hot potato volume lulls everyone into an illusion of healthy markets possessing liquidity, when in fact the markets have become shelled out and hollow.

Tomorrow, maybe we’ll talk about who benefits from volume.