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 [8]" which as is now known, indemnified all forms of high frequency trading (even as subsequently it was found [9], 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) [10]
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 [11] 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.
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: |
| 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:
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. Hitting sell orders decreases (removes) liquidity available to buyers. Buyers can buy 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 [12]. 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 [11] (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.