It was back in 2014, right around the time Michael Lewis published Flash Boys that the public's attention first fully focused on High Frequency Trading, and when we said that it was only a matter of time before HFT became the ultimate scapegoat du jour of all that is wrong with capital markets, "because since virtually nobody really understands what HFT does, it can just as easily be flipped from innocent market bystander which "provides liquidity" to the root of all evil" we said.
In other words: the high freaks are about to become the most convenient, and "misunderstood" scapegoat, for when the market finally does crash. Which means that those HFT-associated terms which very few recognize now, especially those on either side of the pro/anti-HFT debate who have very strong opinions but zero factual grasp of the matter, will become part of the daily jargon as the anti-HFT wave sweeps through the land.
To underscore this prediction, we made it vividly clear what wouldhappen:
@LongOnlyTrader Only until market crashes. Then HFT will be the torches and pitchforks scapegoat. Not the Fed.— zerohedge (@zerohedge) March 31, 2014
Nearly five years later, the time to blame HFTs has finally arrived, because during a roundtable interview today at Bloomberg's Washington office, Treasury Secretary Steven Mnuchin blamed soaring volatility in the equity markets on high-speed trading adding that he planned to conduct an inter-agency review of market structure.
“Over a longer period of time the market reflects various different economic components but a normal trading day now is a 500-point range. A lot of that has to do with market structure, and that’s something we’re going to take a look at,” Mnuchin said.
In other words, while for over a decade, HFTs - in coordination with the Fed - were happily bidding up stocks and lifting risk assets higher to everyone's delight, nobody had any problems with the algos that have come to dominate market structure while soaking up liquidity and making the market increasingly more fragile and susceptible to flash crashes as we discussed most recently in June...
... just two months of selling by various quants, algos and of course, HFTs, and lo and behold, it's time for a comprehensive market overhaul because - you know - it's all the algos fault (just ignore the $4.5 trillion elephant in the room please).
10 years of algos artificially pushing stocks higher, not a peep.— zerohedge (@zerohedge) December 18, 2018
2 months of algos selling and it's time for a market overhaul
Mnuchin - a former Goldmanite and hedge fund manager - told Bloomberg he will ask the Financial Stability Oversight Council, which he heads, to study stock market volatility. While he has not “pre-judged” what exactly is behind the sharp moves before a review is complete, Mnuchin said problems with market structure “may be one of the reasons.”
He is, of course, correct but if one really wants to get to the bottom of market structure issues, one wonders why none of this took place years and years earlier when HFTs were becoming the dominant market-making - and liquidity sapping - force. Why wait until the market is on the verge of a bear market before finally engaging? The simple answer: the Trump admin, which naively decided it was prudent to inherit the bubble of a stock market, is now desperately looking for scapegoats.
And yes, the market under Trump has been increasingly chaotic, because after rising for over a year since his election, in more recent months stocks have fluctuated drastically at times reversing course on his comments about the Federal Reserve’s interest rate hikes, the ongoing trade dispute with China or the possibility of a government shutdown. Equity indexes slid to their lowest close in 14 months on Monday.
“In my opinion, market structure has led to a lot more volatility,” Mnuchin said. “Part of this is a combination of the market presence of high-frequency traders combined with the Volcker Rule.”
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As Bloomberg notes, when regulators had previously sought to boost oversight, they always faced intense pushback from the industry of parasites, pardon, HFTers, which however got so big in recent years, it started cannibalizing itself and the result was countless HFT outfits going out of business as it became virtually impossible to frontrun ordinary orderflow - the bread and butter of the high frequency traders.
The industry pushback was so intense - as the profits from frontrunning were so extensive - regulators simply gave up: After calling for a crackdown on aggressive high-frequency trading in 2014, former Securities and Exchange Commission Chair Mary Jo White conceded before leaving office in 2016 that a fix had proved difficult. Wall Street’s main regulator still hasn’t passed a significant rule to curb the practice.
Meanwhile, the SEC itself has become complicit and has done virtually nothing to rein in the practice is that it’s concerned that making any changes to modern, electronic markets will cause more harm than good. It's correct: changing market structure now that it is dominated by HFTs will likely lead to a crash; which is also why for the past ten years at least this website was constantly pointing out the inherent dangers in allowing HFT to proliferate.
One can safely say that it's too late to change market structure now.
And for an example of just why, recall what Brian Levine, the co-head of Global Equities Trading at Goldman Sachs said this past June when he laid out the one thing that keeps him up at night: as he admits in an interview, "what’s more worrisome to me is a real flash crash, which I define as a situation when the market "breaks."
Indeed, the market breaking is surely high on the list of every trader’s worst nightmares, and reminds us of what we predicted several years ago, namely that when the “big one” finally hits for whatever reason, there won’t be a 20%, 30%, 40% or more drop in seconds: the market will simply be halted indefinitely. This is how Levine describes his own trading nightmare, the one in which the crash is not a “flash” and the market simply breaks:
The data is wrong, everything trades at dislocated prices relative to the NBBO, and everyone—justifiably—widens their spreads. That happens almost every time there’s volatility, largely because message traffic increases dramatically. This is due to the fact that the opportunity set is greater and there’s no economic disincentive for sending messages to the market, so more electronic orders come in. This slows the system, widening spreads and generating price dislocations, which triggers even more orders and compounds the delays—a predicament that is only further exacerbated by the fragmentation of the equity markets. As this happens, stocks may trade outside of the NBBO briefly in millisecond or microsecond increments, constituting what I consider a genuine flash crash. All of this becomes a negative feedback loop that causes more volatility.
Interestingly, if you define a flash crash by the percentage of executions that took place outside the NBBO, one of the largest ones occurred in 2008 after the first TARP bill failed, according to internal analysis we did a few years ago. And the market didn’t snap back, with the SPX closing down 10% on the day and on its lows. I think that may have been why there wasn’t talk of a “flash crash” afterward, but clearly the market structurally failed pretty badly that day, too. This suggests to me that, in a situation with actual bad news, the current US market structure may not be able to handle it, and there could be a downward spiral.
In other words, there will come a day “with actual bad news” when the selling onslaught is so broad, not even BTFD HFTs will be able to resist the sudden avalanche of selling. That’s the day when the increasingly fragile market, one in which “liquidity is the new leverage” will officially break and stocks will “trade outside of the NBBO constituting a genuine flash crash” in a “negative feedback loop that causes more volatility.” A selloff from which there will be no “snap back.”
Of course, here skeptics would be quick counter to this worst case scenario: how come it has never happened yet? The answer was simple: so far, every time the market crashed, central banks stepped in (as Bank of America recently showed).
Which is also why any attempt to truly fix the capital markets will require not only eradicating the destructive influence of HFTs, but also the pernicious impact of central banks, whose $15 trillion in liquidity made a mockery of price discovery, fundamental analysis and finance in general.
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In addition to slamming HFTs, in a tip to his former employer Goldman, Mnuchin also blamed the Volcker Rule, which made it very difficult (but not impossible) for banks to trade as prop agents for much of the post Dodd-Frank period.
Of course, Wall Street - which was left out in the cold and unable to trade as a hedge fund following the Volcker Rule passage - which in turn impaired such glorified, FDIC-insured hedge funds as Goldman Sachs - had long argued that the rule is unnecessarily complex, almost impossible to adhere to and prevented banks from executing trades on behalf of clients (in reality it prevented prop traders from executing giant year-end bonuses). Partly in response to those concerns, the Federal Reserve and other regulators are working on an overhaul of Volcker.
Finally, Mnuchin also added that FSOC also would “probably” look into the potential risk posed by the $1.3 billion market for leveraged loans that often backs mergers and acquisitions of highly-indebted companies. Mnuchin, though, said he doesn’t “have the same concern at the moment” about the market, which has been the subject of warnings from the Fed and the Office of the Comptroller of the Currency.
"I have heard a lot of people express that concern. I don’t have the same concern at the moment, but having said that it is an area that given people have expressed concern we will probably want to take a look at."