HFT quote bombardment blamed for flash crash in May

declining market

Traders continue to be haunted by the May 6 ‘flash crash’ – when US equity markets tumbled nearly 1,000 points in an unprecedented half-hour period – and they won’t be reassured by one of the latest attempts to explain it, which claims the trigger was a deliberate attempt to overwhelm creaking market infrastructure.

The story has been pieced together by US-based market data provider Nanex, using archived quote and trade information for all US equity, options and futures exchanges – a proprietary database that contains around 2.5 trillion quotes and trades, with 7.6 billion individual pieces of information relating to market activity on the day of the crash alone.

“Starting at 14:42 and about 46 seconds, we found there was a delay between the consolidated quote provided by the New York Stock Exchange (NYSE) and the quotes provided by the rest of the market. That delay eventually stretched to about 24 seconds,” says Eric Hunsader, a software developer at Nanex in Chicago.

The delay at the NYSE wasn’t initially visible because quotes from individual markets are all time-stamped when they leave the Consolidated Quotation System (CQS), which aggregates and disseminates bid and offer information for all US markets. Nanex tracked the problem down to the NYSE by looking at the exchange’s second quote feed – its OpenBook service, which is provided to anyone willing to pay $5,000 a month for direct quotes rather than waiting fractions of a second longer for the CQS data. While the OpenBook quotes were in line with other trading venues, the NYSE’s consolidated quotes ended up crossing the market – because of the time lag, the exchange appeared to be willing to buy stock at a level that was higher than the rest of the market was willing to sell, Hunsader says.

The anomaly had two impacts, Hunsader claims – some firms pulled out of the market instantly, while others tried to make a quick profit by buying from other exchanges and flooding the NYSE with sell orders. The exchange consequently switched from electronic execution to an auction market-only mode, in an attempt to slow the market.

“The NYSE switched into a different mode – what it calls a liquidity replenishment point – but notification was sent out in the same way as the consolidated quote, so that was delayed too and no-one knew what was going on. What happens in this mode is that sell orders just get thrown against whatever bids are on the NYSE’s books – and as they are executed, every single one is at least a penny or more lower in price than the previous one and the sizes are odd sizes. We think that was responsible for the final 200–250 points in the Dow’s drop,” he says.

The NYSE declined to comment for this article, citing the ongoing flash crash investigation by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), but much of the Nanex theory is understood to be correct. A source with knowledge of the NYSE’s IT infrastructure confirms the exchange has been making efforts to upgrade the systems behind the consolidated quote and that roughly half of the job had been completed before May 6. “The thing Nanex spotted was probably the result of a huge wave of message traffic hitting this set of servers that had not yet been upgraded and, when put under so much pressure, they lagged behind the direct feeds,” he says. 

The episode has wider importance, though. The second half of Nanex’s theory is more contentious – Hunsader says some high-frequency trading (HFT) firms are bombarding markets with quotes in an apparent attempt to slow one venue relative to others. “We ran into occasions where we saw one stock have maybe 5,000 quotes in a single second – sometimes we’d see 30 quotes in a single millisecond – and that was shocking to see. We started looking at the prices and sizes and we realised those quotes had no business being there. It seemed to us that it was a way for someone to affect the latency for others receiving data,” he says.

Others share that belief. Jos Schmitt, chief executive of Canadian equity market Alpha ATS, says he decided to introduce an order threshold during the first half of last year that would slow down access to the market for any participant exceeding certain levels of order entry per second. “We saw the quote-to-trade ratio for some participants going up to almost 500 to one, with many of those orders at prices far from being tradable. I have no doubt that HFT firms add value, but market-places have a role to manage those that abuse. I don’t believe someone quoting multiple hundreds of times more than what he is trading is trying to add value. The best-performing HFT firms in Canada are averaging a 40-to-one quote-to-trade ratio,” he says.

Whether it’s malicious or not, the growing volume of equity market traffic is a problem, says Doug Clark, head of quantitative execution services at BMO Capital Markets in Toronto. “I would strongly state the number of HFT guys doing this is very small compared with the total population – a lot of them are up in arms about it – but it is happening and you can see it evolving in a way that means it can be used to affect specific markets,” he says.

Market participants expect a new SEC report on the flash crash to be published in September, with the joint SEC-CFTC report to follow in October.

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