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Guest Post: Why Did The “Flash Crash” Occur?
Submitted by Vahid R. Riasati, Ph.D.
Why did the “Flash Crash” occur?
Often and in many conversations the reason is side-stepped via “Perfect Storm” arguments. This warrant’s a brief discussion. One point of view is based on the economic and market factors and behavior which is the basis of many opinions. This involves deductive reasoning that can often be traced back to the deductive reasoner ’s expertise: ‘…we see the world as we are not as it is…’. Looking at the print that goes-by et cetera… The fact is HFT does not rely on traditional events and sector trends and performances, except in very sophisticated systems and event then in secondary considerations, also, most HFT programs do not currently incorporate emotions as decision cycles are reviewed; hence, emotions, sector trends, and traditional events arguments become mute.
HFT algorithms often rely on some simple technical indicators. They can be triggered by a variety of events, but generally involve normalized price volume relationships; like velocities and accelerations over these independent variables, so one would observe price per volume and price per volume squared. The important factor that should be the focus of most discussions is not the particular reason the HFT algorithms send huge orders into the market via flashes of time that incorporate these order volumes in tens or hundreds of microseconds, rather, the issue that should be discussed is how these orders are processed and filled? Recently, at the, IQPC’s “Next Generation Algorithmic Trading Strategies Summit,” I witnessed a flurry of discussion on the topic of “Flash Crash” and the desire to prevent this-type of event from ever occurring again: for various apparent reasons. I found much of the discussion addressed many related themes relevant to the “Flash Crash,” and provided an anecdote that may be interesting to a broader audience.
I began my career in Optics with Professor Richard Fork who held the world record at the time on the shortest optical pulse ever invented: 15 femto-Seconds. Dr. Fork’s light pulse occurred so fast that every molecular dynamic illuminated by it would look frozen. Hundreds or even thousands of these pulses could illuminate a microscopic scene and provide a static picture. They occurred so fast that the dynamics of the microscopic scene did not change prior to the completion of light pulse train in the medium. This is essentially what occurred during the “Flash Crash.” The Brownian motion that describes the price of stocks essentially froze in the perspective of the fast flashes of orders that encompassed the market and the particular stocks’ dynamic behavior during the “illumination.” The correlation of the process with itself reached unity and the equilibrium status of the floating stock price was breached. This circumstance could have occurred under a variety of different scenarios and one can expect that due to the principle of large numbers, it will occur more often than is expected with normal statistics.
Essentially, because the number of orders in the market have increased these so called perfect storms, rare in pre-HFT days, will occur with more ‘regularity.’ However, from my vantage point, I believe the solution to this problem is available and rests in fragmentation of orders and the filling of these orders through unobservable pools of demand that are undetectable by the market. A large order is often used by the HFT as a signal to trade further. The HFT is often ignorant about the reason the large order is occurring it merely measures its attributes and initiates a new order due to its physical occurrence. There exists well-established techniques that segment well-characterized signals and fragment them into other signals that are small in magnitude when detected at the receiver at any instant in time, and sum to a miniscule number, simply by the way they are arranged and characterized relative to each other. This keeps any un-intended receiver/’predatory program’ from detecting and monitoring the orders/signals. All this occurs with negligible effects relative to the user and her intended receiver: the investor and the market that fills the order.
What was really interesting to me was that the Markets/ Wall-Street already appear to have a system in place that can enable the spreading of the order signals. This system was described earlier in the IQPC conference in a talk given by Dr. Robert Barnes, Managing Director of UBS Investment Bank, to be published next month in “The Handbook of World Stock, Derivative & Commodity Exchanges.” Dr. Barnes and others can develop methodology that fragments the orders, the key here is that the fragmentation must be performed in appropriate settings and distinct methods focused to enable the signals’ un-delectability. Under appropriate construction, Dr. Barnes and associates will in fact render the issue of “Flash Crash” events mute by removing the factors that caused its development. The law of large numbers will essentially be segmented into many venues, or alternatively, the short time associated with the large order events is segmented into spatial dimensions that encompass their magnitudes and render their time behaviors undetectable by the HFT algorithms.
Many algorithm designers may dislike this approach, as it will make the algorithm designer’s life much more difficult. However, I would point out that events such as the “Flash Crash,” could undermine the markets and take away their efficiency and believe this should be guarded against as much as possible.
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Does anyone listen to Max Keiser or Gerald Celente? They discuss the real reason for the flash crash. Does Fin Reg ring a bell?
plocequ1,
Spot on.
DavidC
Dr. Riasati needs to remember that for every measure there is a counter measure.
Of course that would mean that the 'flash crash' moves orders of magnitude into a WMFD type range.
Ban 'em and lets trade.
Or, and much easier, they can stop quote stuffing and make each quote good for, say, a second.
DavidC
William of Okham would suggest that it was premeditated theft like everything else in this crumbling country?
You could be onto something:
Yeah, you really need to look at the fruit of these algos, not the mechanics involved. Some guy woke up one day and said "let's use computers to front-run the market".
innovation...
Second time this week I've read an article where the author used "mute" when they meant "moot".
Anyhoo, I'm no math PHD, but if we break up a large order into many small ones, wouldn't the algo's simply be tweaked to find a pattern among the many small orders that indicates a larger order? Momentum is momentum, no?
And why can we not simply enforce a speed limit? OR even enforce the current regulations regarding the requirement that orders must be made with the intent to complete? Intent can be quantified after all. Is an individual or even a large fund cancelling a handful, maybe even a hundred orders mean they didn't have intent to complete when the order was first issued? Probably not. Is it reasonable to think that an organization cancelling thousands of orders per second, all day long, doesn't have intent to complete the order? Probably yes. So determine a reasonable number of cancellations and enforce it!
Can't remember where I read it, I think it was Karl Denninger, where it was suggested that a cancellation fee be charged. So, the more cancellations, the higher the amount to be paid to the Exchange.
DavidC
Personally I found "the signals’ un-delectability" funnier. Surprised at the lack of chatter as to the general quality of this article (writing/getting to the point), which seems low. If this is how they talk at the PhD's euphemistic "Next Generation Algorithmic Trading" conference, I'll pass.
There is one critical change needed to ensure orderly markets:
Buy/Sell orders must be live for a minimum of one second.
One second is the minimum time for human reaction. This prevents HFT software from having a time-frequency advantage.
All exchanges should have their systems changed to reject order cancels within 1 second - or hold cancels until the minimum time is elapsed.
This also has the advantage of slowing the hardware/software arms-race in trading systems. I was talking to an account manager from the London Stock Exchange recently. They are on the point of replacing their £200 million "TradElect" exchange software with "Millenium". A major driver is performance. The change is hugely expensive for them and 1000 client firms. Yet the old system would be fine for years if orders had a minimum lifespan as suggested above.
The hardware/software trading arms-race is essentially a tax on retail investors who wind up paying for it in increased spreads and commissions.
NO sub pennies is crucial.
wintermute ,
Great point.
I've said it before, that it all becomes self defeating and chasing one's own tail. More massive expense, more algos to write and for what? I quote stuff you to slow you down, you quote stuff me to slow me down and he quote stuffs us both to slow us both down. And so on and so on...
A bit like the markets generally at the moment - insane.
DavidC
Millenium...very, very fast. :=) Faster than you can thin...k...(ping)...
Buy/Sell orders must be live for a minimum of one second.
Agreed, this is the best solution because its the simplest one that works.
Eliminating sub-pennying as suggested in the responses would probably complete a very robust solution that could be written in a single-page law that even Congress could understand :-)
However, it is important to note that the flash crash happened at the exact time when leading proponents of Ron Paul's Fed Audit were being "spoken (demonstrated) to" behind closed doors. When they opened the doors, a watered down and virtually useless audit was being proposed by these same people... HFT is an important tool of the Treasury and Fed to manipulate prices higher as part of the illusion (delusion) they're clinging to in hopes of Dems not being slaughtered wholesale in historic numbers in the November election. It might also come in handy if a new Republican controlled Congress tries to pass a proper Fed audit again. Expect far more massive resistance to this than just the trading houses could normally muster, and a probable Obama veto as he feigns free market leanings...
Annoymike, I believe you are correct. Without sub penny trades they could not step ahead of the trades already in the Market. They would have to get in line like everyone else does. If someone is ahead of you, on the time of their trade you have to wait for them to get a fill first. They would have a more difficult time controling the direction of a stock as they could not block the taking out of a bid or the taking out of an ask.
Sub pennying is the way they control the Market.
They could put up a bid at the ask but they would be last in line and if it was cancled it would not matter. Or on the other side they could put in a sell but again they would be at the end of the line of quotes already in the system.
How do they get away with sub penny quotes anyway? No Brokerage or the NYSE can put in sub penny quotes. Why is this even allowed?
Yes you can. And i dont mean with your $5/trade discount brokerage.
SEC WIRES UP
http://williambanzai7.blogspot.com/2010/09/sec-gets-wired-up.html
Again the Flash Crash story? Come on.. nothing to see here... move on...
I think some of the discussions in the article are "moot". Systems of this complexity are prone to catastrophic error. Stability breeds instability.
I believe that liberal sodomy above was going in your direction:
Hahaha, right on. It doesn't take anyone brighter than a simple mechanic to tell you that the rate of failure in a system goes up as that system is infested with more and more moving parts. The entire financial system has become one big Rube Goldberg machine.
Risk factors are better served using abundant historical data, and even then outliers are common especially with leverage involved. Therefore, wihout historical data to manage risk and no rule changes put in place to prevent flash crashes, we are destined for a similar event.
There is something Morally wrong with a Computer Trading Stocks where the intent is not to buy and hold a stock or to sell a stock but to only generate a sub penny profit and a rebate for liquidity from the Exchanges.
It distorts the reason and purpose of a Stock Market. Which in my opinion is for "investors" buying a piece of a Company and their potential earnings. Or for Companies to raise capital for investment or expansion.
HFT is being used to take value out of the Market and the Companies every day. Day by day. The more that is taken out there is less and less for the Companies they Investors. Just, seems to me to be a coordinated Theft by the Big Banks that run the Computers.
It appears that this behavior is being Condoned by the Government. You would think that with all of the Money the Banks made on the 2008 Financial Crash, the Trillions given to the Banks by the Government in the aftermath that they would at least stop the continuation of the confisication of Money from the Public.
But, with the Banks being undercapatalized, everyone in the Government is turning a blind eye. But, what about the Middle Class people they are taking this Money from. Why doesn't anyone care?
Debating why the Flash-Crash happened is like arguing about why a hurricane has an eye in its center. The forces in play will now ensure it *will* happen again, the only parameter that is unknown is the frequency and magnitude.
So, I guess they're not all that perfect after all, eh? Takes ordinary circumstances to produce a storm now that the trading strategies have "evolved". The avalanche producing grains of sand are now proliferating.
Sub Penny quotes should be stopped now. Either that or allow everyone else to put in sub penny quotes.
How is it that the Computers can break the rules and are even allowed to trade in sub pennys? That is not an accepted standard of practice. If they ban sub penny quotes will they go to sub sub penny quotes.
Any trade under one cents should be banned. Immediatly. No 90 days to discuss the matter. They are not allowed now by any of the exchanges for NYSE or traders.
If not the banning of sub penny quotes the Exchanges should set a policy to kick out any quote below a penny so they cannot be executed on or entered into the system.
Sometimes Wall Street needs to police themselves. But, will the Exchanges do it with paying them Rebate Fees for all the sub penny quotes that are immediatly cancled. I wonder if they get rebates on the trades even if they are cancled.
Wonder if the overstuffing of quotes that get cancled has to do with the rebate for liquidity. So, every millisecond you make a bid for 20,000 shares and cancle it a millisecond later. Almost looks like they are trying to bleed the exchanges dry.
Same thing happened with Google with their adds. There were programs designed to continuously click on their adds. This added to Googles revenue. But, Google did put a stop to it with a program to detect over clicking.
The stock exchange should do the same.
The Exchanges should only pay a rebate on trades actually executed. That would put a stop to flooding the system with quotes that are cancled before any human could execute a trade on the so called liquidity. It is not liquidity it is just flashing an order that cannot be humanly possible to execute on.
Rebates are only paid on executed orders, not quotes.
I think with all those discussions about HFT one main point is lost; what was the original purpose of stock markets.
All those PHD's instead of working on research and development of new and existing technologies in medicine, space, IT, manufacturing, agriculture and so on, are working on stealing money from others. And who are those others? Of course they do this to themselves, but probably that part of the game is zero sum because they use similar indicators and tactics and only difference, at given time, is equipment and some brains (which often change employers in hunt for better pasture). Earlier or later they have to have the same idea and will crash the market or go like crazy other way. The second group they're stealing money from are little savers and investors, and you have to say if they using those tactics to screw pension plans, mutual funds or smaller money management firms, still it ends up as the losses for us.
Why author of this post who started his career in optics has not continued in that field? Everything possible to discover or work on was done and nothing left in that field to achieve? And all those guys taking part in the "Next Generation Algorithmic Trading Strategies Summit" are working now on better methods to part us with all those few pennies left in our pockets, that's great! I guess they are future of American science and technology and will keep America at the top of the world for sure.
scab tech
Like Warren Buffet says
"beware of the geek with an idea"
nuff said
...and beware of Warren Buffett.
Its simple to eliminate this type of order flow. Just tax every DAY order that hits any electronic exchange whatever amount to deter orders that might cause issues such as syndicate/penalty bids suddenly disappearing?!?
http://www.advfn.com/news_Schumer-Asks-SEC-To-Study-Rapid-Trading-Role-i...
At least we know when it all crashes this time, their won't be any of this watching the tape pour out for weeks like in the 20's or 30's, it'll all happen in the flash of a second and that'll be it folks!
My solution is to opt out completely until HFT is out of the market.
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