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capital 50 THEEDGE mal aysia   |  november 1, 2010

derivatives world

The crash of 2.45 – lessons learnt

y previous article highlighted the 2.40pm transacted prices was only disclosed cusing more on flash orders (or flash trades).
events that brought on the short- at the close of market. An observation from Flash trades occur when exchanges send trade
est-lived stock market crash in by May 6 is that market participants’ uncertainty orders to a select group of participants (for a
American history. There are in- Jasvin Josen about which trades will be broken can affect fee), a fraction of a second before revealing them
valuable lessons to be learnt from their willingness to provide liquidity. publicly. Flash orders are offered by a number
the crash and this article will To provide market participants more cer- of stock exchanges, like the Nasdaq, DirectEdge
discuss some of the notable ones. Let us not forget that the 1987 crash was tainty as to which trades will be broken and and BATS Exchange. There is a likelihood that
triggered by similar instruments. Back then, allow them to better manage their risks, the this privilege may be removed to be fair to all
The dark side of automated electronic various funds were using programme trading process for breaking erroneous trades now uses market participants.
trading to perform “portfolio insurance” strategies, more objective standards. On Sept 10, the SEC
Electronic trading was developed in the late trading derivatives (futures and options) to approved the new trade break procedures on a Lesson for Malaysia and Asia
1980s and has turned into a market necessity dynamically hedge equity portfolios.That day, pilot basis where conditions for broken trades Many Asian markets are already offering elec-
today. From May 22 to 26, 2010, programme trad- also against a stressed market background, are clearly spelled out. For example, “ For stocks tronic trading and some even offer direct algo-
ing was 60.8% of the New York Stock Exchange’s liquidity dried up in the futures markets and priced US$25 or less, trades will be broken if the rithmic trading, linking clients directly to the
(NYSE) average daily volume. (source: automat- the panic spread to the cash markets. trades are at least 10% away from the circuit exchange. Bursa Malaysia is one of those which Exchanges are competing with breaker trigger price” and so on. recently allowed UBS to launch its algorithmic
each other for the fastest processing times to Time for circuit breakers to keep up trading platform on the exchange. It is only a
complete trades. In June 2007, the London Stock with the times ETFs can be very vulnerable matter of time before Asia faces the same chal-
Exchange introduced “TradElect” that promised The main difference between the May 6 crash instruments lenges of the US. HFTs will most certainly ex-
an average 10 millisecond turnaround time from and the 1987 crash was that the former only It is widely believed that the “flash crash” pand to Asia over the next several years.
placing an order to final confirmation, and can lasted 20 minutes.The 1987 crash only partially propagated so quickly to the stock market be- However, after the experience in the US, we
process 3,000 orders per second (source: Does rebounded after two days and took two years cause of the popularity of the SPDR ETF that can expect Asian markets to be more equipped
Algorithmic Trading Improve Liquidity, 2008 by to recover completely, allowing the panic to that tracks the S&P 500 index (SPY). The SPY with regulation and controls for automated
Hendershott, Jones, Menkveld) spread to global markets. has become the preferred instrument of arbi- and algorithmic trading. Perhaps this will slow
As more electronic systems opened in the The reason -- subtle mini-circuit breakers trageurs who trade off discrepancies between down the evolution in Asian markets, but defi-
exchanges, market players began to launch al- designed to restore order in times of panic. the futures and cash markets. Since the E-Mini nitely make them more orderly.
gorithmic trading strategies to interact with Orders will bypass the main exchanges to less (the most liquid equity index futures contract
the automated systems of the exchanges. Ma- liquid venues that take a longer time to process in the US) was tumbling ahead of the stock Conclusion
chines can react more rapidly to temporary orders. As observed, pausing a market can be market, arbitrageurs started to buy the E-Mini The “flash crash” reminds us of how mod-
mispricing and can examine prices from several an effective way of providing time for market futures and sell the SPY ETF. As a result, the E- ern markets operate. In the words of Michael
markets simultaneously. Algorithmic trading participants to reassess their strategies, for al- Mini contract started rebounding, while the Yoshikami, chief Investment strategist at YC-
systems are used by different type of traders gorithms to reset their parameters, and for an SPY kept falling. MNET Advisors, “We have one firm, that ac-
-- high frequency traders, arbitrageurs and orderly market to be re-established. It is not clear how the SEC intends to tackle cording to the SEC really was the trigger of
fundamental investors. This strategy ultimately saved the May 6 this issue; after all, this is merely an inherent this whole cascade ... When you consider the
The benefits of automation come with risks. crash. However, one can never rest on one’s lau- risk of any ETF that tracks a market or index. number of firms out there making trades the
The “flash crash” of May 6 demonstrated that rels. It is said that orders bypassing the NYSE possibility this could happen again, in my
under stressed market conditions, the auto- and going to less liquid (and often manual) High frequency traders and flash opinion, is very high.”
mated execution of a large sell order can trig- venues explained some of the dramatic prices trading need to be watched over? The stability of our financial exchanges will
ger extreme price movements, especially if the seen on May 6. While the system is designed to Technological advances in recent years have be called into question at a future time. It is
algorithm does not take prices into account. restore order on the Big Board, the incredibly enabled very fast analysis of information and just a matter of how we will handle it, rather
Worse still, when computers talk to each other fast trading during times of panic may have transfer of data. This saw the beginning of a than escape it.
in a tense environment, liquidity erodes quickly swamped these less liquid venues.That’s when new type of trader taking advantage of these At the same time, capital markets in Asia
resulting in disorderly markets. market makers had to quote “stub quotes”, advances: the high frequency trader (HFT). should not make the mistake of shying away
which could be as low as a penny a share. The main strategy of HFTs is to react very from index futures and ETFs. Instead, while
The intimate relationship between Regulators now acknowledge the need to quickly to tiny price changes in either direc- learning from the oversights of the West, Asia
stock and futures markets recalibrate the existing market and plant wide tion, not to make big bets on big price changes should concurrently allow creativity and inno-
May 6 reminds us of how a futures market can circuit breakers that apply across all equity in one direction. The large volume trades un- vation to evolve the markets naturally.
affect a stock market in minutes. Automated trading venues and the futures markets. In dertaken by HFTs narrow bid-offer spreads
trading has closely linked stock and futures, fact, circuit breaker pilot programmes have among stocks. Their fast and reliable execu- Jasvin Josen is a specialist in developing
where changes in one feeds through the other already been implemented for individual se- tion speeds enhance trading volumes for US methodologies for valuation of various
at tremendous speed. The US Securities and curities across the S&P 500 index, the Russell exchanges, creating a healthy marketplace derivative products. She has over 10
Exchange Commission- 1000 index and some ETFs. for price formation. Nevertheless, HFTs have years’ experience in investment banking
US Commodity Futures Trading Commission been condemned for allegedly pulling out of and the financial industry in Europe
(SEC-CFTC) report released on Oct 1 makes it Uncertainty about broken trades the market on May 6, which saw stock prices and Asia. Comments: jasvin@gmail.
very clear that the action in the E-Mini futures affects market liquidity suddenly plunge before recovering. com. Readers may also follow her at
led the sell-off in shares and exchange-traded The exchanges’ decision to cancel broken trades It is not clear at this point what lies ahead
funds (ETFs). that were trading more than 60% from the for the HFTs, but it appears that the SEC is fo- (Derivatives World)