Was The SEC "Explanation" Of The Flash Crash Maliciously Fabricated Or Completely Flawed Out Of Plain Incompetence?

Tyler Durden's picture

Regular readers know that since the beginning, Zero Hedge has been vehemently opposed to the official SEC explanation of the chain of events that brought upon the Flash Crash of May 6, 2010, in which the Dow Jones Industrial Average lost 1000 points in a span of seconds, and during which billions were lost when stop loss orders were triggered catching hapless victims unaware (unless of course, one had a stop loss well beyond a reasonable interval of 20%, in which case the trades were simply DKed). It is no secret that one of the main reasons why the retail investor has since declared a boycott of capital markets, which lasts to this day, and manifests itself in hundreds of billions pulled out of equities and deposited into bonds and hard assets, has been precisely the SEC's unwillingness to probe into this still open issue, and not only come up with a reasonable and accurate explanation for what truly happened, but hold anyone responsible for the biggest market crash in history in absolute terms. Instead, the SEC, naively has been pushing forth a ridiculous story that the entire market crash was the doing of one small mutual fund: Waddell and Reed, and its 75,000 E-mini trade, which initially was opposed to being scapegoated, but subsequently went oddly radio silent. Well, if they didn't mind shouldering the blame, the SEC was likely right, most would say. However, as virtually always happens, most would be wrong. Over the past few days, Nanex has one again, without any assistance from the regulators or any third parties, managed to unravel a critical component of the entire 104 page SEC "findings" which as is now known, indemnified all forms of high frequency trading (even as subsequently it was found, again by Nanex, that it was precisely HFT quote churning that was the primary, if not sole, reason for the catastrophic chain of events) with a finding so profound which in turn discredits the entire analytical framework of the SEC report, and makes it null and void.

In essence, what Nanex finds is that the paper's authors completely botched the logical chain of events in their definition of "who did what" in those fateful minutes between 14:43 and 14:45, strayed from all classical definitions of liquidity to allow them to goal seek their conclusion, and ultimately misdiagnosed everything that happened on May 6, also known as Flash Crash day.

Nanex' approach is simple and elegant: they unravel the fundamental argument at the core of the entire paper, and thus the SEC's conclusion, with definitive factual proof and material evidence. And in doing so they make all the primary and tangential conclusions of the SEC invalid.

The only open question is whether the SEC, which certainly co-opted the authors of the paper to reach the desired conclusion, real facts be damned, acted out of malice and maliciously fabricated the data knowing very well the evidence does not support the conclusion, or, just as bad, was the entire supporting cast and crew so glaringly incompetent they did not understand what they were looking at in the first place.

Unfortunately, either option is equally sad, and since one of the two has to be right, and neither one will make the retail investor even remotely comfortable with dipping their toe back into stocks, we can definitively say that the true culprit here, High Frequency Trading, will continue to drive ever more true sources of capital out of stocks and into other markets, until the very fabric of the market stretches so thin that the entire thing explodes under its own weight.

And with that the proudest chapter of America's once revolutionary, and now just plain sad, capital markets, will officially be over.

Below we present Nanex's complete write up and observations, as well as full chain of communication with one of the paper's co-authors. We urge readers to read it in its entirety as it shows either just how incompetent the SEC truly is, or how corrupt. We leave it up to our readers to decide which is worse.

 


 

Nanex ~ The SEC Redefines Liquidity (when it's convenient)

April 12, 2012

While rereading the SEC's flash crash report,  Findings Regarding the Market Events of May 6, 2010, and a very similar report written at the same time by some of the same authors, we came across statements that are clearly false, and grossly mischaracterize the algorithm that executed the 75,000 S&P futures contracts and blamed for causing the flash crash. Be sure to see our recently updated detailed analysis and charts of the contracts sold by the algo.

We contacted one of the co-authors and things grew murkier. The email exchange was very disturbing because the explanation was basically a new and bizarre definition of liquidity in an attempt to try and make the paper's text agree with the facts. That, or the authors have based the foundation of the entire paper on a very unusual interpretation of liquidity: something that would completely nullify any conclusion. The SEC report for example, uses the word "liquidity" 249 times in 89 pages: a word that may now have a completely different meaning from anyone's current understanding of that term.

This bizarre definition of liquidity basically states that if a High Frequency Trader (HFT) aggressively buys contracts by executing against existing orders posted by a seller, then the HFT could be classified as a liquidity provider, and the seller classified as a liquidity taker.

Read that again, because it is exactly opposite of the industry accepted understanding of liquidity, not to mention, basic common sense. It's like saying up is down and down is up.

This revelation makes you wonder what other non-standard definitions were used. It seems they were trying to fit the data to match a foregone conclusion. What follows is the email exchange between Nanex and the co-author. W&R refers to Waddell & Reed. Timestamps are Eastern Daylight and date is M/D/YYYY.

 

On 4/9/2012 1:24 PM, Nanex wrote:

I recently reread your paper with Andrei Kirilenko titled: The Flash Crash: The Impact of High Frequency Trading on an Electronic Market.

Something stood out that I didn't notice before.

Page 36

Thus, during the early moments of this sell program’s execution, HFTs and Intermediaries provided liquidity to this sell order.

..

As they sold contracts, HFTs were no longer providers of liquidity to the selling program. In fact, HFTs competed for liquidity with the selling program, further amplifying the price impact of this program.

We know the algo used by W&R never took liquidity (it always posted sell orders above the market, never crossing the bid/ask spread). That directly opposes the statement above. Can you help me resolve the two?

On 4/10/2012 10:24 AM, Co-author wrote:

Perhaps we need to express ourselves more clearly.

It is possible for the HFTs to provide liquidity to a sell order by purchasing at the sell order's offer, as a result of which the HFTs accumulate inventory. Our graphs show that after accumulating inventories of 3,000+ contracts, the HFTs avoided further inventory accumulation.

Thanks for pointing this out.

I am cc-ing my other co-authors in case they have information to add.

On 4/10/2012 10:42 AM, Nanex wrote:

This is a first. I must admit, I have never seen liquidity defined that way. And it doesn't seem to match other definitions, implied or otherwise, in your paper. Just one example I found in less than a minute:

From page 15:

In order to further characterize whether categories of traders were primarily takers of liquidity, we compute the ratio of transactions in which they removed liquidity from the market as a share of their transactions. (footnote 7).

footnote 7:
When any two orders in this market are matched, the CME Globex platform automatically classi?es an order as ‘Aggressive’ when it is executed against a ‘Passive’ order that was resting in the limit order book. From a liquidity standpoint, a passive order (either to buy or to sell) has provided visible liquidity to the market and an aggressive order has taken liquidity from the market.

On 4/10/2012 11:32 AM, Co-author wrote:

I agree that our terminology is confusing. We need some clear language to distinguish between hitting a bid or lifting an offer (aggressiveness) and providing liquidity by being willing to take on inventories when others want to sell.

By the way, exactly the same issue came up in the 1987 stock market crash.

On 4/10/2012 12:17 PM, Nanex wrote:

Actually you do have clear and consistent language with respect to liquidity and aggressiveness. The only issue is that the W&R trades don't fit into the characterization. That algo was always passive and always provided liquidity to buyers.
On 4/10/2012 1:14 PM, Co-author wrote:

So perhaps we need to change the language we use to describe what happened at the beginning of the flash crash.

These are useful comments, so I will share them with my co-authors.

On 4/11/2012 9:05 AM, Nanex wrote:

I've shared our email exchange with a few market savvy colleagues and they are equally confused by your statement regarding liquidity:

It is possible for the HFTs to provide liquidity to a sell order by purchasing at the sell order's offer, as a result of which the HFTs accumulate inventory.

In addition, the above statement still doesn't clear up my original question:


Page 36

Thus, during the early moments of this sell program’s execution, HFTs and Intermediaries provided liquidity to this sell order.
..

As they sold contracts, HFTs were no longer providers of liquidity to the selling program. In fact, HFTs competed for liquidity with the selling program, further amplifying the price impact of this program.

We know the algo used by W&R never took liquidity (it always posted sell orders above the market, never crossing the bid/ask spread). That directly opposes the statement above. Can you help me resolve the two?

The W&R algo never took liquidity so it couldn't possibly compete for it. If no more buyers showed up on May 6, 2010, it wouldn't have completed the full order. It would have ended the day selling fewer than 75,000 contracts.

Here are the commonly accepted definitions of liquidity makers and takers:

Posting sell orders to the book increases (provides more) liquidity available to buyers. Buyers can buy more without impacting the market.
Posting buy orders to the book increases (provides more) liquidity available to sellers. Sellers can sell more without impacting the market.

Hitting sell orders decreases (removes) liquidity available to buyers. Buyers can buy less before impacting the market.
Hitting buy orders decreases (removes) liquidity available to sellers. Sellers can sell less before impacting the market.

We never received a reply to our last email. We hope, maybe, a light bulb went off. We have more questions.

Saying that a HFT execution of a sell order resting in the book is adding liquidity is just plain wrong: even if you know that the sell order is from a fundamental seller. There is simply one less sell order available to another buyer, it's as simple as that. It might help to understand this if we reverse the direction: If a HFT hits a buyer order, would that ever be considered adding liquidity? Of course not!

Does it matter if the trader is HFT or not?  Intention is impossible to determine without an interview, even with audit trail data. Besides, even knowing the intention still opens a Pandora's box. For example, what if a fundamental buyer executes against an order placed by a fundamental seller? Is one adding liquidity and the other removing it? Which one? What if the HFT executes against an order placed by another HFT? What if a HFT seller places and cancels 1,000 sell orders in a second with no intention of any being executed? Do you get the picture?

Orders added to the book, regardless if they are buy or sell orders (so long as they are legitimate),  add liquidity. Executing against any resting order is removing liquidity. Their paper actually says this in the footnotes at the bottom of  page 15 (which was pointed out in our second email)!

From a liquidity standpoint, a passive order (either to buy or to sell) has provided visible liquidity to the market and an aggressive order has taken liquidity from the market. 

This whole thing reeks of less than honest research. To base any future regulations on either of these papers would be ill-advised and reckless. Someone needs to do some serious house cleaning at the SEC and CFTC.

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phungus_mungus's picture

all the world is a masquerade made up of fools and philosophers, were it to rain on our charade all washes away except our true colors...

Richard Chesler's picture

The mission of the U.S. Securities and Exchange Commission is to give the illusion they protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.

BoNeSxxx's picture

I'll take "the entire supporting cast and crew so glaringly incompetent they did not understand what they were looking at in the first place." for $1,000 Alex.

ACP's picture

No need to worry, there's enough news about what George Zimmerman bought in the jailhouse store and about who Kim Kardashian screwed last night to keep the public's minds off what is really important.

bernorange's picture

What? No fat fingers?

CIABS's picture

Dumb or devious, as they say.

AldousHuxley's picture

liquidity = unnecessary fluctuations artificially created by TBTF meant to profit the market exchanges and not the participants.

 

You don't need sub-second liquidity for markets to function. It is all for banksters trying to make money on volume of money flow.

AlaricBalth's picture

The authors knew precisely what they were looking at and chose to obfuscate their findings. When these so called "civil servants" venture out into the private sector, they do not want to risk being black balled due to an unfavorable report implicating the very industry in which they wish to be employed.

Excursionist's picture

Honestly, I'm not so sure..  Your view is predicated on the authors' fully understanding equity market mechanics.  The question I ask myself is, "What kind of a person opts to slave away at the SEC or at a third-party consultancy that advises the SEC?"  Is it a retired "A" player who made millions trading for a prop desk, hedge fund, etc. and now wants to show his altruism within the halls of a government bureaucracy?  I think it's highly unlikely..

Think about this alternate possibility:  if you're a high-level official at a regulatory agency, which may be co-opted by those it regulates, AND wish to propagate a particular narrative that happens to be at odds with the fact base AND for career reasons wish to have plausible deniability in case of blowback, then what better way to achieve your ends then to assign the investigation to Larry, Moe and Curly?

Let's say the findings surfaced by NANEX actually gain traction.  Where do you think the buck will stop at the SEC?  With the SEC study's authors or the authors' supervisor?  My money is on the former.  The surpervisor would claim something along the lines of the flash crash study being just one of 25 under his / her purview, can't possibly be accountable for every report generated by trusted 'experts', etc., etc.

Just as important as understanding market mechanics is understanding bureaucracy mechanics if you wish to uncover the truth.

Gringo Viejo's picture

Incompetent? No. Malicious? Beyond measure.

ShankyS's picture

So if Peter Noth pulls out is that removing liquidity? Maybe the SEC can get the situation right in that context. 

Dingleberry's picture

Shank......WORD!!!

I wonder how many fellow ZHers have seen the "great white north" and his liquidity to fully appreciate your analogy.

Shizzmoney's picture

The mission of the U.S. Securities and Exchange Commission is to give the illusion they protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.

And to download porn.  Which has been the only thing they have successfully been good at the last 25 years.

tooktheredpill's picture

i reckon a bit of both. The gov would want a bunch of numpties over there (like the ratings agencies) so they can be manipulated more easily. There would need to be a filter somewhere though to ensure the truth does not come out. Where the gov is paid to despise regulation the SEC cannot be taken seriously.

candyman's picture

For some, here is a prime example of the diminishing returns we are getting from our education system and Government. For others...it's exactly what has been planned. For old schoolers this is completely FUpped!

HelluvaEngineer's picture

You know, the better question is why after that event, whenever something begins to flash crash, why does the hand of God step in?  There is obviously a federally-backed buy program in place.  In other words, in bureaucratic terms, this constitutes "fixing" the problem.

Imminent Crucible's picture

A malicious fabrication or plain incompetence? Why can't it be both: An incompetent fabrication with malice?

The SEC co-author should be flogged for his devious dodging and weaving. Along with every other bloodsucking leech at the SEC.

SolidSnake961's picture

what do u expect from the securities and porn watching commision?

Bubble's picture

Plain Incompetence. Sorry, no time to explain, trading a stock and need to put 300x ADV out in 3c increments in the next 0.3 of a second....

Bubble's picture

Feck, actually got lifted on my offers. Well, a teeny bit of them. Pulled the rest after I realised there was a mkt buy order. Jumped in front of it and bought back my shorts and went long in front of him. Praise zero latency DMA. Lucky I don't pay brokerage fees so my broker can tell his real customers what a big mkt share they trade....

T-Bond's picture

The whole thing reeks of a payoff.

Metalredneck's picture

If only we could follow the money.

The Axe's picture

What can I say, these are basic..the very basic understanding of the market...yet authors and co-authors answer questions like ,,,like idiots... If they cannot fathom the passive bid and offerings of a book, as liquidity  vs the agressive lifting or hitting of a trader or algo. What chance do they have of understanding a complex question/?  omg fucking nuts.....SEC is a fuckhole of stupid.

Archduke's picture

Dunno about the US, but I do know a few Traders who switched to a ratings agency, the FSA, and back again.

To me this indicates that the regulatory authorities are not entirely staffed with ineptitude and incompetence.

 

I would be tempted to assume not gratuitous malice, but rather interested complicity, collusion and corruption.

 

slewie the pi-rat's picture

  <----<  malicious

 <----< incompetent

when we are on this square 2 years after (!):

On 4/10/2012 1:14 PM, Co-author wrote:

So perhaps we need to change the language we use to describe what happened at the beginning of the flash crash.

These are useful comments, so I will share them with my co-authors.

%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%%

well, since it doesn't describe what happened, perhaps slewie isn't the only one for whom the "sincere, innocent effort" excuse doesn't always get a moronic free pass

i'm voting for malice;  this is bullshit;  $100 Mil of goobermint trolling!  at least!   bull. shit.

Likstane's picture

Hate'm or love'm, it's the real mouse!

Overflow-admin's picture

Actually, I would say both: they must be malicious to make such bold false statements (google is your friend) AND they must be completely incompetent (in social engineering) to be unable to desguise their lies.

 

I vote malice for it's the root cause IMHO.

RECISION's picture

+1 Malice

The SEC is doing exactly what it is designed to do.

Deflect the heat off the top crooks.

- Kill investigations when necessary/possible.

- Prosecute no-bodies who bring the wrong sort of attention.

- Spread B/S, smoke and mirrors, whenever possible.

- Sit on any sort of process for as long as possible (forever if possible).

But most importantly:

-Prevent any other Law Enforcement agency from investigating, because this is their bailiwick, and they will fight tooth and claw to keep any outside eyes away.

That is NOT incompetence or accident.

It is Malice aforethought.

Whether it started out more or less legitimate, and was then captured...

Or was Corrupt from the start...

It is unquestionably now a criminal conspiracy to provide a teflon-overcoat/get-out-of-jail-free pass, to the top mafia crooks.

The Cops are bought and paid for - they serve and protect - their Bosses.

Capo's for the Don(s)

spastic_colon's picture

Yes well...as we know all investigations conducted by any "official" agency all follow the script of the Kennedy assassination analysis.

Yes_Questions's picture

 

 

SEC: Captured Entity, Seriously.

Raynja's picture

Complicit or complacent theres no fucking difference.

Yes_Questions's picture

 

 

You're right: there are no Innocent Bystanders.  Certainly not when it comes to an agency ostensibly chartered to oversee the conduct of participants engaged in activities so near the heart of the monetary economy.

 

What's the relative equivalent here of torches and pitchforks?

 

 

illyia's picture

A flood of this post to the SEC in all it iterations.

espirit's picture

Illiquidity will starve the bloodsuckers.  Let the Hunger Games begin.

Yes_Questions's picture

 

 

And may the odds be ever in OUR favour..

TheCanimal's picture

I completely lost faith in the stock market & it's feeble regulators after the flash crash and soon after cashed in chips that had been in the game for nearly 30 years.  The only thing worse is Jon Corzine still walking the streets after stealing customer funds.  I won't be returning. 

sof_hannibal's picture

"Everybody knows the good guys lost; Everybody knows the fight was fixed; The poor stay poor, the rich get rich.."

Uber Vandal's picture

No, no, no.

The problem is that the poor have too much and the rich do not have enough.

sof_hannibal's picture

Shocking... yawn.. let the algos trade this bitch to zero 0... kill the host and the parasites die !

"This was freedom. Losing all hope [ium] was freedom..."

DavidC's picture

Nanex, and Joe and Sal at Themis Trading, have been absolutely at the forefront of HFT and Algo trading since before 2008.

http://www.nanex.net/FlashCrash/OngoingResearch.html
http://blog.themistrading.com/

DavidC

tpgaynor's picture

Ron Paul....the final solution!

tony bonn's picture

in a world where the magic bullet theory and the pancake theory are declared with straight faces, this latest bucket of shit from the nazi high command can be heard without guffaws....

sof_hannibal's picture

Quick To the FED printing Führer's bunker

ziggy59's picture

Choice D). all the above

navy62802's picture

Kudos to NANEX for not dropping this and doing their brilliant research. Glad to see they are still pursuing this.

pashley1411's picture

I wish someone would explore the potential of asymetric market participants; while there are rules set to preserve an orderly market, certain participants are presumptively self-policing and so allowed to trade outside those rules.

Those asymetric particpants (CIA, JP Morgan, space aliens) use their priviledged status to game the market to their advantage.   These particpants aren't to display their nature, that would frighten the cattle, but occasionally inadvertently display their presence when the market displays anomalous behavior.