Several weeks ago, Goldman’s Chief Markets Economist Charlie Himmelberg became the latest Wall Street strategist to admit the threat to the market posed by HFT. Picking up on our original warning from April 2009, the Goldman strategist warned that HFTs – due to their inability to process nuanced fundamental information – may trigger surprisingly large drops in liquidity that exacerbate price declines, and result in flash crashes.
Himmelberg highlighted the growing market share of HFT and algorithmic trading across all markets, and warned that the growing lack of traditional, human market-makers has made the market increasingly fragile.
He is, of course, correct as active traders will attest, if nothing else then by the collapse in market liquidity around critical, market-moving events when HFTs strategically “pull out” from the market, making price swings especially sharp and resulting in a spike in volatility as shown in the schematic below.
As we discussed in greater detail back in April, the relentless, and increasingly commoditized ascent of HFTs, as well as the change to market structure and topology in a post-Reg NMS world, prompted Himmelberg to conclude that we live in a world where the biggest threat is not market leverage, but periods of sudden, unexpected and acute losses of liquidity. Or, as he put it, “liquidity is the new leverage.” This is how he explained it:
That analogy is meant to invoke the potential unrecognized problems or imbalances that build up over the course of long expansions. Financial leverage was obviously the imbalance that built up during the pre-crisis period, but that has been contained in the current cycle. In this cycle, there have been dramatic shifts in the way that secondary markets source liquidity, but this market structure has not yet been stress-tested by a recession or major market event. I therefore see a risk that markets are paying too little attention to liquidity risk, much as they previously paid too little attention to the risks posed by excess leverage.
Furthermore, the fact that for the past decade global capital markets and risk assets have been constantly prodded higher courtesy of central bank liquidity injections, has exposed them to increasing instability not only at the micro level but at the macro: while virtually HFTs – and roughly 30% of all active asset managers (who were simply too young during the global financial crisis) have never encountered a market crash, the big test will be what happens, and how the market would react during the next crisis in which there is no “big picture” central bank intervention, to make “buying the dip” at the micro, HFT level, the correct response, even though so far aggressively purchasing the “crash” has been the correct response every single time…
… as volatility always inevitably tumbled, making selling vol one of the preferred “carry” strategies for numerous investors classes (ultimately leading to the historic VIX explosion of February 5 which blew up several of the most popular retail vol-selling strategies such as inverse VIX ETNs in a matter of minutes).
But what if what HFTs do is nothing really new: what if the liquidity collapse that results in such flash crashes as the May 2010 US “Flash Crash”, the October 2014 10Y Treasury “Flash Rally”, the October 2016 Pound Sterling “Flash Event” and the February 2018 VIX Spike, are merely an accelerated version of events that took place repeatedly in market history, if only on a much more accelerated timeframe?
That is the point made by Brian Levine, Goldman’s co-head of Global Equities Trading, who in a recent “Top of Mind” interview with Goldman’s Allison Nathan. When asked if he is “concerned that HFTs cause or exacerbate flash crashes by reducing liquidity”, Levine’s response was oddly sanguine for a man who oversees one of the world’s most active trading desks.
Noting that “scarce liquidity in volatile markets is nothing new”, Levine counters that the risk of HFTs causing or exacerbating flash crashes by reducing liquidity is “overstated” and notes that while we may live in a time of “HFT stop” when market depth suddenly evaporates, “in the days of manual markets, market makers just didn’t answer their phones.”
For example, in the ’87 crash, people were really crowded on one side of the trade and all ran for the exit at the same time. This isn’t much different than a hypothetical scenario today in which systematic strategies all try to exit a position at once. It might happen within a few seconds instead of the 20 minutes it took for someone to answer the phone.
Furthermore, Levine sees an almost beneficial role played by HFTs who help the “market readjusts quickly today.”
Not everyone agrees. Many investors feel uncomfortable with a stock falling to 70 from 80 in a very short period of time. But I don’t think there’s anything inherently wrong with that. Bottom line, I don’t blame HFTs for flash crashes. In the grand scheme of things, these players do little to improve or worsen the situation. Remember, they generally end the day flat—they’re not taking much market risk.
And while that is correct, the wild market swings created by HFTs can and often do prompt those who are increasingly on edge about market structure, stability and asset overvaluation – here the culprit is as much the Fed as HFTs due to the injection of $20 trillion in liquidity by the world’s central banks over the past decade – to commence liquidating assets, resulting in a selling cascade, one which becomes self-reinforcing and ultimately results in a crash, even if so far every such crash has been bought up either by HFTs or central banks, whether directly or through jawboning – everyone remembers St Louis Fed president James Bullard explicitly hinting at QE4 during the market’s sharp correction in October 2014 which unleashed a furious buying spree and halted the selloff.
But while Levine may not be too worried about the HFTs’ role in creating and propagating flash crashes, there is one aspect of that the current broken market structure that does keep him up at night. As he admits in the 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 (see “How the market is like SYNC which was 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 have a quick counter to this worst case scenario: how come it has never happened yet? The answer is simple: so far, every time the market crashed, central banks stepped in (as Bank of America recently showed).
And, more ominously, as of this moment – for the first time in the past decade – central banks, that ultimate backstop of every market crash, are once again draining liquidity…
… which, as we and Deutsche Bank explained previously, together with central bank tightening has been the catalyst for every major “market event”, whether economic recession or market crash or both in the post-Fed era.
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