by tyler durdan from zero hedge
HFT Market Making May Lead to a Crash
Rambus (RMBS) fell 30% today in a matter of five minutes. It immediately bounced back. The cause for this move was speculated as a trader with a “fat finger”. A trader simply messed up and sold too much stock accidentally, causing a swift and violent sell-off.
The trades were later deemed erroneous and busted by the exchange.
But what if the real cause wasn’t just a trader with a “fat finger”, accidentally selling too much stock? What if it was something more serious? I believe it is. I believe the real cause for this move is a major concern for our markets. The real cause may have been high frequency market making gone bad. Let me explain.
Market making is the practice of quoting both bids and offers on the same security, in hopes of capturing the spread. Market making has existed in our markets since the beginning. Traditionally it was done by floor brokers, floor traders and specialists. With the rise of the internet in the last 1990s, new players emerged in the market making practice. Proprietary traders, and E-traders began to play the game. This led to increased competition and tighter spreads. But in the past five years a new player has emerged, and this player has become dominant, knocking many of the competitors out of the game. This new player is the high frequency algorithmic trader, and it’s not a person, it’s a computer. 70% of our daily volume is now done by algorithmic computer systems. Much of this volume is market making. Why has the HFT computer become such a dominant player? It has to do with their edge.
High frequency algorithmic systems have been programmed to step inside the NBBO (National Best Bid and Offer), and be the best bid and best offer. This puts the computer system at the front of the line to be first for execution, and gives the computer the best chance to capture the spread. Unfortunately, this practice is dominated by a few large firms, and they have driven traditional market makers out of the market. If a traditional market maker places a bid, the computer automatically steps in front. In some cases, it steps in front by as little as 1/100th of a penny (a practice called sub-pennying, which is discussed on my website
http://www.defendtrading.com).
These programs are very predatory and step in front of the NBBO on a constant basis. This has driven liquidity providers out of the market. Our proprietary trading firm, Bright Trading LLC, in the early 2000s, used to account for 2% of the volume on the NYSE. Now we account for just a fraction of that. Our 400 traders used to provide a substantial amount of liquidity to the market. But due to predatory HFT market making practices, we now provide very little liquidity. We are now liquidity takers. The rational is simple, if we place a passive limit order (providing liquidity), the HFT algorithmic programs simply step in front of us. If we do get filled on a passive order, it is almost always because we are wrong. You are sub-pennied when you’re right, filled when you’re wrong. Hence, there is no point to us providing liquidity. Other proprietary trading firms, floor traders, and specialists are in the same boat. There is no way for them to compete with the algorithmic programs, so they don’t place passive orders.
Without traditional market makers, willing to step up and be the buyer of last resort, we risk having more incidents, like the Rambus incident.Computerized algorithmic market making works in any type of oscillating market, as the computer can keep flipping out of it’s longs, and covering it’s shorts. It works in a trending market, as long as there is some type of choppy trade. The problem lies, when the computer system can’t flip out of the position. Most algorithmic systems are programmed with some type of risk parameter. If this risk parameter is breached, the computer will dump it’s position and cut it’s losses. This is what may have happened in RMBS today.
An algorithmic system making markets on the long side, got too long, and was unable to wiggle out of the position because of the follow-through in selling pressure. Once it was down so much in the position (the risk parameter was breached), it dumped. This simply added fuel to the fire. That is why the sudden plunge to $16 happened. If you check the chart, you will not see this, because Nasdaq busted all trades under $22. But don’t kid yourself, these trades happened, and we should be very alarmed, because it will happen again, and it may happen to the entire stock market.High frequency traders make markets on ALL stocks. As they continue to take dominance, and as more and more liquidity providers are driven out of the market by these HFT predatory algorithms, the likelihood of a crash continues to climb. All it takes is a little bad news, and a breach in the HFT’s algorithmic system’s risk parameters, and we’re in a lot of trouble.
This has happened before, it WILL happen again.
Rambus was ONE stock today. Imagine if it was the entire market.
Dennis Dick, CFA
Bright Trading LLC
