Who Will Be Blamed?

It was one week ago, when we read with great curiosity (and commented on) a research report drafted by none other than the NY Fed called "The Liquidity Mirage", which was not only a confirmation of our article from July explaining "How High Frequency Traders Broke, And Manipulated, The Treasury Market On October 15, 2014", but a validation of all our work since we first wrote our inaugural post on the dangers from HFT on that long ago April 10, 2009: "The Incredibly Shrinking Market Liquidity, Or The Upcoming Black Swan Of Black Swans" (for those who have not read it, it may be an interesting read: over 6 years ago, when virtually nobody had head of HFT, it predicted just how the market would break under the weight of the fake liquidity provided by these very "liquidity provider" as it did for the first, and certainly not last, time on August 24).

None of the authors' conclusions were surprising: we have been repeating for years that what HFTs do is create a broken market topology at the micro level, where the noise of an infinite of HFTs algos becomes the signal in itself, and whenever a major countertrend move happens, the market simply shuts down as these "New Normal" liquidity providers are simply finely-tuned momentum creation and frontrunning machines, and most certainly not market makers.

What was curious is that the NY Fed went one step further than the Joint Staff Report released in July of this year, which stopped just short of blaming HFTs for the October 2014 Treasury flash crash. The NY Fed report did not have such qualms and openly accused HFTs of generating the conditions that were necessary and sufficient for the October 15 2014 flash crash (and every other one both before and since following the implementation of Reg NMS). From the report:

This situation, which we term the liquidity mirage, arises because market participants respond not only to news about fundamentals but also market activity itself. This can lead to order placement and execution in one market affecting liquidity provision across related markets almost instantly. The modern market structure therefore implicitly involves a trade-off between increased price efficiency and heightened uncertainty about the overall available liquidity in the market."

Our take:

Goodbye to "fat fingers" being blamed for flash crashes, and welcome to the Heisenberg uncertainty market: you can have your 1 millicent bid/ask spreads... but you can't have any real market depth at the same time.

Which then leads to the logical and final question: why do this? Why admit (not only that we have been right all along), but that HFTs - far from a benign influence on the market - are a latent threat one which may lead at any given moment, to a market crash so profound the only recourse is "circuit breaking" the entire market?

Our conclusion from a week ago is what we have said for the past 6 years: HFTs have become the perfectly willing and eager scapegoat, one which will be blamed for everything that is wrong when the next crash finally comes.

In other words, from market predator HFTs are now one millisecond - and market crash - away from become regulatory prey. Why? Simple: so these culprit which have broken the market at the micro level deflect all attention from those responsible for breaking the market at the macro level: the central banks. This was our conclusion:

In the aftermath of this report, one can be sure that the days of current market structure are numbered, and that the scene is now set to throw the book at the HFTs. The only thing that is missing is the appropriate catalyst. And what is better than an orchestrated, or ad hoc, market crash, one which exonerates the real culprit for the stock market bubble - the Federal Reserve - and unleashes populist anger by millions of investors who lose their net worth in an HFT instant, aimed squarely at the HFTs, and the 20-year-old math PhDs behind them?

A few days ago, in his latest article "Invisible Threads: Matrix Edition", Epsilon Theory's Ben Hunt confirmed just that. To wit:

... you can bet that whenever an earthquake like this happens, especially when it’s triggered by two invisible tectonic plates like put gamma and call gamma and then cascades through arcane geologies like options expiration dates and ETF pricing software, both the media and self-interested parties will begin a mad rush to find someone or something a tad bit more obvious to blame. This has to be presented in soundbite fashion, and there’s no need for a rifle when a shotgun will make more noise and scatters over more potential villains. So you end up getting every investment process that uses a computer – from high frequency trading to risk parity allocations to derivative hedges – all lumped together in one big shotgun blast.…you use computers and math, so you must be part of the problem.

Hunt may disagree with this blunt assessment, and he may revolt at the "prejudice" against the algos, but what he is missing is the far bigger question: why? Why is the "computer trading" crowd is being primed for the biggest fall ever. The answer is simple - someone has to be held accountable.

Whether it is a scapegoat why Leon Cooperman crashed in August and blamed Ray Dalio's "risk parity" trade, or why Ray Dalio indirectly blamed the Fed when "smart beta" suddenly became very dumb, or why the Fed, which will have seen trillions in fake paper wealth evaporate overnight, will need to deflect the anger of a few billion furious investors worldwide out for blood, someone will need to take the fall.

That someone will be those who use "computers and math" to trade, or - as we have shown it repeatedly in the past for "soundbite" reasons - look like this:

And best of all, you can't arrest a vacuum tube, or lynch an algo: the market can wipe itself out... and nobody will go to prison.

Which means that the only question is when will this scapegoating kangaroo court of diversion begin; answering that question will also answer when the next, and most epic yet, market crash will take place.