Lessons Learned from the Flash Crash
Today, May 6th, marks the fourth anniversary of the infamous "flash crash" in which the Dow experienced a 9% drop only to recover losses within minutes. The event lasted roughly twenty-five minutes but unfortunately has become inextricably – and inaccurately – linked to the high frequency trading industry ever since. We've previously examined and dispelled inaccuracies about what has triggered the flash crash so in this post, we outline lessons learned and best actions to take for moving towards an even safer and more robust market:
Lesson 1: Market complexity must be considered.
Markets are more interconnected than ever before. Global markets move in unison across venues, products and asset classes. U.S. equities exchanges are now also routing broker/dealers.
The desire for one position can stimulate movement across thirteen lit venues and scores of dark pools. While such action is great for accurate, real-time pricing of assets it also means that market issues are far reaching with larger consequences.
And so it goes that market complexity is a byproduct of market interconnectedness. Modifying complex systems to protect against risks and minimizing impact of failures is often a catch-22, in which taking action against one issue may create or exacerbate another problem.
So what's the best action to take against complexity? Simplify.
The SEC is currently preparing for a holistic market review (which we all should work together to ensure) will better inform market participants and regulators on effective solutions that do not add to the overwhelming complexity of our markets.
Lesson 2: Firms and exchanges must guard against operational risks.
Increased operational risk has always accompanied technology advancements. While the flash crash was the first high profile market event to raise the concern of operational risk to entire market, such risk has always been an important concern for the high frequency trading industry. After all, issue prevention and detection are not only key in ensuring operational safety but also vital to the HFT firms' bottom line.
With regard to issue prevention, the SEC's proposed (and currently voluntary) Regulation Systems Compliance and Integrity (Reg SCI) aims to ensure the integrity and resilience of key systems used to run the U.S. securities markets. The proposed regulation seeks to institutionalize systems planning and testing in order to strengthen the underpinnings of our market and is currently set to be finalized in 2014.
No automated environment can prevent every issue. The ability to detect that something is out of the ordinary, and pause activity so that order can be restored, is crucial. One of the first concrete reactions to the flash crash was the creation of (U.S. Equities) marketwide circuit breakers and halts. We should continue to look for similar mechanisms that are effective and can be safely implemented without adding to the overwhelming complexity of our markets.
The onus of preventing operational risk is on all market participants. Any firm that trades electronically should strive to minimize operational risk and the impact of any issues. Every trading firm should implement a wide variety of kill switches, safety checks, and fail safes. All firms should critically examine all aspects of their infrastructure, diligently test and strengthen their systems, and follow tested, proven processes for rolling out changes.
Managing system-wide operational risk will require constant vigilance by all market participants.
Lesson 3: Accurate and timely data must be secured.
A lack of easy access to accurate data delayed examination of the flash crash. Since then, regulators have been working to ensure they have the necessary information on markets. Indeed, the better access regulators have to accurate data, the better equipped they will be to craft rules and regulations that promote efficient and robust markets.
The more data that our regulators can audit and study in a timely manner, the more informed they will be in crafting the rules and regulations that shape our market.
MIDAS, which gives the SEC the ability to examine market data, is a great start but more can be done. Other priorities toward this end may include: attributable data, access to data from dark pools and internalizers, and clear, accurate payment for order flow information. The Consolidated Audit Trail – if implemented correctly – could do a great deal to satisfy these needs.
What's another way to secure accurate data on market actions? Industry firms providing information through registrations. No one should be allowed to operate in the shadows, hidden from regulators. Many firms are registered in some way already. Preeminent trading firms already send every order with the expectation of regulatory audits because they know doing so is the only way to run a sustainable and responsible business.
Moving Forward
Over the past decade, technological advancements have greatly improved market conditions for end investors. To wit: quote spreads have been cut nearly in half, the amount of displayed depth has tripled and investor costs have fallen. Over the last month many traditional firms have attested to the benefits high frequency trading has provided their clients.
Conditions are great for the retail investor; however, the markets are not perfect. Much can be learned from the flash crash and the subsequent discussions and changes. There have been many positive changes but there is more to do, as can be seen in surveying the above lessons learned.
All industries that have benefited from automation know that the more transparent and understandable the system, the less likely malfunctions and glitches will occur. The financial markets are no different. We should all continue to push forward on initiatives that will secure the benefits provided by technology advancements and strengthen our markets.
- MMI
About the Modern Markets Initiative (MMI):
The Modern Markets Initiative (MMI) was organized in 2013 by leading quantitative trading firms to engage and educate public audiences about the value modern market professionals provide to today's electronic marketplace.
Modern Markets Initiative (MMI) members: Global Trading Systems (GTS), Hudson River Trading (HRT), Quantlab Financial and Tower Research Capital.
Modern Markets Initiative, 1667 K Street NW Suite 520, Washington, D.C. 20006 United States
No comments:
Post a Comment