ANALYSIS-Study casts doubt on traders’ ‘raison d’etre’

By Reuters Staff
October 12, 2010

By Herbert Lash

NEW YORK, Oct 12 (Reuters) – A new study about May’s “flash crash” casts doubt on two basic premises of high-frequency traders: that they help markets function properly by providing liquidity and that they smooth out price volatility.

High frequency traders have pointed with glee to the fact a mutual fund company, identified as Waddell & Reed Financial Inc, helped trigger the steep market plunge on May 6, as outlined by U.S. regulators in a report almost two weeks ago.

Yet the new study by staff of the Commodity Futures Trading Commission to be unveiled on Tuesday not only gnaws at the service high-frequency traders claim to provide but says their response to that day’s slide sparked greater volatility.

“We conclude that high frequency traders did not trigger the flash crash, but their responses to the unusually large selling pressure on that day exacerbated market volatility,” said the study, which is not an official position of the CFTC.

High-frequency traders provide very short-term liquidity and their activity makes up a large percentage of trading volume, the study said. Yet their contribution to high trading volumes may be mistaken for liquidity, it said.

The fast traders do not accumulate large positions nor are they willing to accept large losses, so when they rebalance their positions high-frequency traders may compete for liquidity and amplify price volatility, the study said.

“The Flash Crash: the Impact of High Frequency Trading on an Electronic Market,” is not against technological innovation; the four authors actually embrace it.

But the study said “appropriate safeguards must be implemented to keep pace with trading practices enabled by advances in technology.”

David Cummings, founder and chairman of Tradebot Systems Inc, a large automated trading firm, said in an e-mail last week entitled “Waddell Stupidity Caused Crash” that those behind the market’s plunge must be held accountable.

Other defenders of high-frequency trading also have derided Waddell, which has said its trade of 75,000 E-Mini S&P 500 futures contracts on May 6 was a bona fide hedge.

Despite the 104-page findings report by the CFTC and Securities and Exchange Commission on Oct. 1, debate about the events of May 6 and the workings of high-frequency traders, or HFT as they’re commonly referred to, still rages.

Eric Hunsader, a software programmer who has become a vocal critic of both the SEC and high-frequency trading, has said close examination of trading on May 6 shows the crash could not have been caused by Waddell.

In fact, the reaction to Waddell’s sell program by high-frequency traders bogged down the national quote system and scared off other market participants, said Hunsader, founder of market data firm Nanex LLC.

Andrei Kirilenko, the CFTC’s senior financial economist, defended the joint SEC-CFTC review of May 6, saying the staff had data showing the exact sequence of transactions.

“We’re not guessing anything. We know exactly whose done what in these markets,” said Kirilenko said. “When you compare our analysis with other things you may be reading, please keep in mind that our data is what is the most exact audit trail that we could find,” he said at a CFTC meeting in Washington.

The new study, whose work was incorporated into the joint CFTC-SEC report, said that the trading behavior of HFTs appears to have exacerbated the market’s plunge.

Waddell’s sell program resulted in the largest net change in the daily position of any trader in the E-Mini S&P 500 futures market since the beginning of 2010, the joint CFTC-SEC findings report said.

Regulators also said that Waddell’s sell order was almost four times what buy-side resting orders, the willingness to buy at prices equal to or above or below current market levels, were prepared to take at the height of the market’s plunge.

When high-frequency trading caught public attention in the summer of 2009 after the arrest of a former Goldman Sachs trader, one of the CFTC-linked study’s authors decided to examine how high-frequency traders interact with the overall market.

“I was aiming to write a paper with Andrei Kirilenko that might have been called “A Day in the Life of the S&P 500 E-mini Contract,” said Albert Kyle, a professor at the University of Maryland who is on the CFTC’s technology advisory committee.

Kirilenko is also one of the study’s authors.

“The project was moving along slowly when the flash crash hit,” Kyle said in an e-mail query. “The result was that our project morphed quite naturally into material that could go into the joint report.” (Additional reporting by Christopher Doering in Washington)

((Reporting by Herbert Lash; Editing by Andrew Hay, Gary Crosse)) ((; +1-646-223-6019; Reuters Messaging:

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