As the second anniversary of the May 6th Flash Crash approaches, it's a good time to take a look at the markets to see what has changed.
Back in May 2010, shortly after the crash and rebound, it became painfully evident that regulators and exchanges were not able to adequately self police the markets. After all, it took about five months for the SEC to release the official Flash Crash report, which many observers immediately skewered as incomplete, not accurate and almost comical.
The official report laid responsibility for May 6, 2010 on an order to sell 75,000 CME E-mini futures contracts. But experts say that while the 75,000 contract order was big, it was not huge, and that there are more than 1 million E-mini futures contracts traded per day. So, the 75,000 contract order could not have disrupted the markets the way it did. Once again, investors were left scratching their heads.
Today, to mark the upcoming 2nd anniversary, Sal Arnuk, an outspoken critic of high frequency trading and partner, co-founder and co-head of equity trading at Themis Trading, sent the following note to clients. In the letter, he discusses how regulators have failed to respond to deteriorating market conditions and what HFT has done to investor confidence:
This Sunday will mark the 2nd anniversary of the May 6th Flash Crash of 2010. As we all trade in this extremely low-volume environment, it is fitting that we recap where we stand today.
Listening to NYSE Euronext's 1st quarter conference call yesterday, we shook our heads in dismay as management described a trading environment where volumes fell to a four and one half year low – the lowest levels since Reg NMS was implemented in late 2007, in fact.
NYSE's Duncan Niederauer explained his 44% profit decline was due largely to a 25% decline in revenues from transactions from a year earlier. The culprit: An unfriendly environment for high frequency trading firms. From his point of view, regulators and folks in the media hyped the HFT bogey man too much, creating uncertainty, causing an HFT migration into other asset classes and geographies.
Niederauer doesn't get it. He is mistaking the symptoms for the underlying problem. HFT volumes are down because investor volumes are down. Investor volumes are down because traditional retail and institutional buyers and sellers of stock have been steadily waking up to the dangers of drinking at the increasingly dangerous "stock market watering hole."
Like the animals on the Serengeti, who for years were accustomed to sipping long and heartily at their favorite spot, retail and institutional investors now see what's beneath the surface. And they are deciding that the drink they crave is just not worth the risk.
More than $250 billion in long term equity funds has retreated from the markets since May 6th, 2010 -- despite a slow but steady improvement in the economy and a stock market that has nearly doubled since the 2009 lows. It isn't that these investors don't have confidence in the economy. They don't have confidence in our markets.
It isn't hard to blame them. They have witnessed a radical transformation of the best capital allocation market system in the world, into one where:
-- 13 stock exchanges cater to hyper traders who game the system, chasing exchange rebates, and leveraging speed for the purpose of a nanosecond scalping dance.
-- More than 40 dark pools together trade more than 1/3rd of all shares.
-- Conflicts of interest abound as exchanges own stakes in dark pools, and HFT firms own stakes in exchanges.
-- Brokerage firm internalization of trades feeds the HFT financial modeling of investor orders.
-- Exchange data feeds act as a veritable DVR of investor orders and behavior, the recording of which is then sold to HFTs.
-- Rogue exchange traded products break down, trap unsophisticated investors, and only enrich the issuers, exchanges, and HFT firms that make markets in them.
-- HFT firms in the last decade have achieved wondrous profitability (double-digit Sharpe ratios) while investors at best have clawed back to even.
-- More than $1 billion in customer-segregated monies goes missing from MF Global, with not a single prosecution, nor a hope of redress.
As they witness all of the above, traditional retail and institutional investors see that our regulators must be having a challenging time acting as effective policemen in the marketplace:
-- Flash orders, which give HFTs a quick peak at retail and institutional orders, are still alive and well, under many different names, despite a proposed banning of them in 2009.
-- Dark pool regulation, also proposed years back, has not materialized.
-- Internalizing brokerage/HFT firms, which clearly played a huge role in the market melt-down on May 6th (perhaps as well in the financial crisis in late 2008 and 2009) still practice the same way, with additional help from dark pools and exchanges who have all embraced "liquidity provider" programs.
-- And finally, payment for order flow (PFOF) is alive and well on numerous levels throughout the system – from retail, to maker/taker exchange pricing, to free dark pool executions.
Investors know that the markets are broken. And they desperately want it fixed.
Our outrage over the transformation of the best capital markets in the world to this conflicted and fragmented web of chaos led us to write our book, Broken Markets: How High Frequency Trading and Predatory Practices on Wall Street are Destroying Investor Confidence and Your Portfolio, which is being published by Financial Times Press.
When the book comes out June 3rd, it will find no shortage of critics from within our industry. However, we needed to write it. For years we have spoken about all of these issues in trade magazines and the financial media, and at industry conferences and panels, as well as with our regulators.
We wrote Broken Markets so that Main Street could understand what happened to our markets, to inspire change, so we can once again have the best capital markets in the world.
So, Happy Anniversary to everybody who made the Flash Crash happen. We hope you are enjoying yourself.
Because we, and millions and millions of other retail and institutional investors around the world, are not.