"May 6 Revisitare"

Sydney M. Williams

Thought of the Day

May 6 Revisitare

October 4, 2010

Mrs. O’Leary’s cow, assuming she survived, I am sure felt badly for kicking over the lantern which allegedly ignited the Chicago fire 129 years ago this coming Sunday. Waddell & Reed (allegedly responsible for the May 6 crash) has similarly expressed remorse, saying they did not intend to “disrupt” the market when they sold $4.1 billion (75,000) in E-Mini S&P 500 futures contract in an algorithmic program trade designed to be executed “without regard to price or time”, at a pace not to exceed 9% of trading volume. However, the fact that high frequency traders (HFTs) traded 27,000 similar contracts in just 14 seconds, meant that staying within their volume parameters was not a problem, as these contracts, like a “hot potato”, were passed back and forth between HFTs – and disruption was indeed a consequence.

Some of the comments about the report seem incredulous. On Friday, Dow Jones Newswires wrote: “Manoj Narang of Tradeworx, a New Jersey-based firm that runs a high-frequency trading fund, said the report underlined that high-frequency traders were not responsible for the market’s plunge. ‘High-frequency trading on its own could never prevent a stampede for the exits like what we saw on May 6,’ Narang said. ‘That’s purely a phenomenon created by herd-like behavior by long term investors’.” Really? It beggars credibility to believe that most long term investors have the wherewithal to react within seconds. Only a computer driven program could react so quickly.

However, not having read the full 104 page report, perhaps the CFTC (Chicago Futures Trading Commission) and the SEC did place the blame solely at the feet of Waddell & Reed. However, the New York Times, on Saturday reported: “As they (HFTs) detected they had amassed excessive ‘long’ positions, they began to sell aggressively, which caused the mutual fund’s algorithm in turn to accelerate its selling.” While Waddell & Reed may have lit the blaze, the numbers of futures contract sold within seconds suggest that HFTs poured gasoline on the fire.

High frequency traders have long claimed that they provide liquidity in a market otherwise deprived. Since their trading, along with other computer-driven programs, account for an estimated 70% of all trading, it appears that the only beneficiary of the liquidity they provide is to one another. The most redeeming aspect of what they do is the enormous profits they generate for themselves. Not only does society not benefit from what they do, in fact they sew the seeds of destruction of a capital system integral to our way of life.

Lost in the reports on the Report, from what I read, is any mention of the importance of capital markets: the markets exist as a means of raising money for businesses and government, providing the opportunity for investors and savers to generate returns on their investments, and allowing for the exchange of investments for cash. Anything that promotes such activity should be encouraged; anything that hampers the essential purposes of these markets should be discouraged. Critical to any investment, of course, is a sense of confidence. The events on May 6 wracked confidence in our capital markets. The Report from the SEC and the CFTC, to the extent it left the HFTs untouched, has done little in my opinion to assuage that loss of confidence.