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Confirming the Flash Crash Omen

Confirming the Flash Crash Omen

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Published by: zerohedge on Jun 03, 2010
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The highly discussed and quickly forgotten Flash Crash was an omen of what lies aheadfor the financial markets. It was a uniquely distinctive occurrence relative to anythingwe’ve ever experienced. Likewise, what we are about to witness will be startling andnever before observed by this generation of investors. After only thirty days the FlashCrash signal has become unambiguous and historians will wonder why the public didn’treact sooner to its clarion call.Prior to the May 6
Flash Crash I laid out what to expect in “Extend & Pretend: ShiftingRisk to the Innocent”. The ink was barely wet before its predictions began torapidlyunfold. The basis for the predictions was the similarities between the rally we have experienced since March 2009 andthe rally prior to the 1987 crash. It was striking in comparison to the amount of rise, the rate and the pattern, butmore importantly the reason for both rallies. The 1987 crash was attributed to Portfolio Insurance. In 2010 it’s aboutwhat is referred to as the ‘son-of-portfolio insurance’ or Dynamic Hedging.Over the last ten years we’ve systematically accelerated the shifting of risk through the advancement of three newstrategies; Dynamic Hedging, Capital Arbitrage and Regulatory Arbitrage. Individually they may seem sound but whenpyramided as we have done over this period of time, they set the stage for systemic instability. The underlyingbedrock of this shaky pyramid is Dynamic Hedging.
For the full research paper: seeTIPPING POINTS 
The three new strategies:Dynamic HedgingReduces Risk further through recent advancements in High Frequency Trading and Dark Pools (1)Capital ArbitrageHides Risk by removing it from financial balance sheetsRegulatory ArbitrageMoves Risk to Sovereign entities.
I won’t explore in this article how these strategies are being used and how they are building upon themselves (see “Extend & Pretend: Shifting Risk to the Innocent”) but rather I want to focus on what the Flash Crash is signaling andhow it relates to the three critical flaws of all modern trading algorithms.The chart above and the May 17
Wall Street Journal confirmed the rational for our April predictions:
On May 6, "The velocity of the volatility was stunning, beyond anything I had ever seen, with the exception of October of 1987, when I was on the trading floor," said Ted Weisberg, president of Seaport Securities in New York."There's a strong parallel between the Black Monday crash and the flash crash," said Michael Wong, an analyst atMorningstar who tracks stock exchanges. On Oct. 19, 1987, the Dow Jones Industrial Average tumbled more than20%, and the swoon extended into the following day, before a rebound. Floor traders, working by telephone,dominated the action and computer-generated trading was still in its infancy. Dark pools and high-frequencytrading were the stuff of science fiction. Trading reached 600 million shares, according to the SEC.Fast forward to May 6, 2010: The worst part of the lightning descent lasted roughly 10 minutes and the decline hit9.8% at its worst. Trades, many executed in milliseconds, reached 19 billion shares. In both cases, troubles firstappeared in the stock futures market, which precipitated a decline in the regular "cash" market. The two created afeedback loop, dragging both markets lower. Perhaps the most concerning parallel was how professionalsabandoned the market. In 1987, some human market-makers on the floor of the exchange stopped providing bidsfor certain stocks.Two decades later, in a market dominated by technology, high-speed traders who often provide liquidity for themarket, just switched off their computers. Other big players, including fast-trading hedge funds, also pulled out of the market, according to traders and exchange officials.
"Go back to the 1987 crash, every major firm pulled out," said Chris Concannon, a senior partner at Virtu FinancialLLC, a New York electronic market making firm, which continued trading during the May 6 turmoil. "In every breakyou find evidence of major firms withdrawing their buying and selling interest from the market." (2)The Financial Times on June 1
wrote:Traders were stunned. “We thought a big European bank was about to go under, that this was it,” says a dealerwho was on one of the big trading floors at the time. “Everyone got on the phone. Then, traders quickly realisedthat the falls were due to lots of automated sell orders. At that point
we all just wanted to reach for theemergency button and press stop.” 
While there have been times in equity markets where some stocks havemoved wildly, the afternoon that has become known as the “flash crash” was the first time that the entire USequity market was convulsed by such turmoil.
But 20 minutes later prices had bounced back. Trades that tookplace during that dramatic slice of the hour where the movement was more than 60 per cent were cancelled. Yetthe impact of the flash crash will be felt for a long time to come, not least because it showed that
the equitymarkets do not have such an emergency button, or any way to halt trading when something goeshaywire
. (3)
Dynamic Hedging and Portfolio Insurance are both based on trend following mechanics.Consequentially both have a strong bias towards momentum correlation and the ability to adjust tochanges in momentum.One of three flaws in most mathematical algorithms is the assumption of market liquidity. Whenmarkets breakdown, liquidity quickly evaporates and this often makes execution impossible. Themore serious the breakdown the more serious the liquidity problem will become. Also, the liquidityissue is often simultaneously seen across multiple markets where modern dynamic hedgingoperates.The Flash Crash confirmed that Dynamic Hedging has now been modified by major players to takethis into account and this is why the algorithms ‘grabbed’ as much liquidity as fast as it could, ataccelerating rates - while liquidity was still available. The employment of High Frequency Trading hasnow emerged as a strategic imperative within state-of-the-art Dynamic Hedging Systems.
Counter Party Risk Driver
A second flaw of trading algorithms and markets is counter party risk or the sudden failure of acounterparty to deliver a contracted obligation. With banks & financial institutions still having seriousamounts of off balance sheet risk tied to Structured Investment Vehicles (SIVs) and corporations toSpecial Purpose Entities (SPEs) the ability to rapidly shift hedging on any early indications is nowparamount.Shifts in LIBOR, TED Spread, and OIS-Swap spread must now be acted upon in milliseconds. TheFlash Crash occurred when all these input drivers were moving as a result of the Euro crisis.

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