Following quite a number of requests this note deals with my understanding of what transpired Thursday the 6th. May when just after 2.30 PM the Dow Industrials collapsed by nearly 10% and then suddenly recovered in 11 minutes. The implications of what occurred are far reaching and unless the regulatory issues are resolved we can expect similar “events” of like nature.
In the main to comprehend the evolving situation in the “Market” one must realise that there are now many markets. In the good old days, in America, all we had was the New York Stock Exchange where real people dealt with real market makers in real time. But computers in general and the internet in particular have changed all that. Now in addition to the NYSE “public market” we have the (OTC) Over the Counter Market. The OTC is basically a private market between banks and large institutions which has little or no active supervision. I find this development strange because the trading activity on the OTC is 60 trillion dollars annually, while turnover on the public market is 5 trillion. Now in addition to public markets and private markets let us now bring “Dark Pools” into our explanation.
“Dark Pools” What are they ? ” Dark pools of liquidity” are crossing networks that provide liquidity that is not displayed on order books. This situation is highly advantageous for institutions that wish to trade very large numbers of shares without showing their hand. Dark liquidity pools thus offer institutions many of the efficiencies associated with trading on the exchanges’ public limit order books but without showing their actions to other parties. This is achieved because neither the price nor the identity of the trading entity needs to be displayed. Many of the OTC “exchanges “used by the dark pools use high frequency trading programmes to minimise order size and maximise order execution. Now you may think that this manner of doing business on the “stock market” is carried out by minor unknown entities but this is not the case. Below I list the Independent dark pools, the broker-dealer dark pools and exchange-owned dark pools that we currently know about.
Independent dark pools: Instinet, Smartpool, Posit, Liquidnet, Nyfix, Pulse Trading, RiverCross and Pipeline Trading.
Broker-dealer dark pools: BNP Paribas, Bank of New York Mellon, Citi, Credit Suisse, Fidelity, Goldman Sachs, Knight Capital, Deutsch Bank, Merrill Lynch, Morgan Stanley, USB, Ballista ATS, BlocSec and Bloomberg.
Exchange-owned dark pools: International Securities Exchange, NYSE Euronext, BATS Trading and Direct Edge.
When you understand that all the big players in banking and finance are using the OTC system and have a turnover 12 times that of the “public” markets you get to wonder why there is a New York Stock Exchange at all. In fact there is a big difference between the OTC “private” market and the NYSE “public” market. The NYSE is comprised of market makers. These market makers are specialists who are obliged to buy and sell on their own and the publics’ account to create a liquid active market. The OTC market faces no such obligation. Over the past number of years attempts have been made to abolish the specialist role and remove the “human” engagement. The events of Thursday last indicate that this would be a move in the wrong direction.
In essence what happened on the 6th May was that the high frequency OTC trading programmes created “maverick trades” (the now infamous fat finger trade) which did not make sense to the NYSE specialists. Accordingly the NYSE stopped handling orders so that the situation could be analysed. The OTC computerized networks then began rerouting orders to other “markets” and with no “public” markets participating prices collapsed through sell stops and the rest is history.
There are many questions to be asked about this event, such as:
1. Is a financial “market” that is only 8% “transparent” actually a market (5 trillion dollar public auction as opposed to a 60 trillion dollar private one).
2. Is it time for more stringent regulation of the OTC market ensuring a more level playing field for all investors.
3. Are additional “circuit breakers” necessary so that high frequency trading is brought deeper into the public management loop.
4. What role is the SEC playing in ensuring that the introduction of new technology cannot compromise systemic integrity.
Whatever the eventual fallout from this mini intra-day crash, technically the market cannot take many repeats. Such re-runs would call into question the confidence the world has in American financial prowess and lead to a breakdown in the macro trend towards global integration of cross- trading networks.
www.wealthbuilder.ie August 2010