Investors: High-Frequency Trading Could Cause Another Flash Crash (SPY, DIA, IWM, VTI)

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February 1, 2012 12:43pm NYSE:DIA NYSE:IWM

David Zeiler: The threat of another flash crash caused by  high-frequency trading is as great as ever. And the next flash crash could be  much worse than the one that shocked investors in May 2010.

Although the Securities and Exchange Commission (SEC) has taken some steps to prevent another flash crash caused by high-frequency trading (HFT), some experts question whether the additional disclosure and  “circuit-breakers” designed to prevent big, sudden price moves will make a  difference.

“Those things won’t prevent another  flash crash – they can’t,” said Money Morning Capital Waves Strategist Shah Gilani. “All they will  do is soften the move.”

The real issue, Gilani said, lies  with the computers that execute the trades – thousands of them in milliseconds.

HFT has changed the nature of the stock  market since these trades now account for between 60% and 70% of the  transactions on the U.S. stock exchanges.

“You can’t stop a flash crash unless  you stop the computers from doing what they’re programmed to do. And that’s not  being addressed,” Gilani said. “The SEC  is looking at keeping the ship from sinking, not stopping it from hitting  icebergs.”

HFT’s heavy volume and high speed  made it the prime suspect in the flash crash of 2010, when the Dow Jones Industrial Average (NYSEAMEX:DIA) plunged more than 600 points in five minutes, before recovering  almost as quickly.

Mini Flash Crashes

Since then, the frequent occurrence  of mini flash crashes – when a single stock or exchange-traded fund (ETF) experiences a steep and rapid drop in price that quickly reverses – have served as nagging  reminders of the vulnerability of the system to such events.

“It’s like seeing cracks in a dam,”  James J. Angel, professor at the McDonough School of Business  atGeorgetown University told The  New York Times. “One day, I don’t know when, there will be another  earthquake.”

Studies of HFT and the 2010 flash  crash have supported the idea that the markets are still vulnerable.

A study commissioned by Barron’s applied the new SEC circuit-breaker rules to trading data from the 2008-2010  period with troubling results.

Had the current trading limits been  in place during the 2010 flash crash, only 14% of stocks in the Russell 1000 would have been affected.

Although not proof the  circuit-breaker rules would fail, the study did show the need for more back  testing of the new rules.

“While I understand the pressure to  “do something’ in the wake of the flash crash, it is disconcerting that no one  has done this sort of back testing in advance of policy decisions,” Casey  King told Barron’s. King, director of the Yale School of Public Health’s  Center for Analytical Sciences and a former Salomon Brothers employee,  conducted the study.

A second study, conducted by the  U.K. Department for Business, Innovation, and Skills, concluded that the  computerized complexity that made the flash crash possible in 2010 make it just  as likely to happen again.

And the next time could be worse.

“The true nightmare scenario would  have been if the crash’s 600-point down-spike, the trillion-dollar write-off,  had occurred immediately before the market close,” the U.K study notes. “The  only reason that this sequence of events was not triggered was down to mere  lucky timing the world’s financial system dodged a bullet.”

High-Frequency Trading Vampires

Adding to the concern is that only  2% of the 20,000 brokerages account for all that high-frequency trading, and  they bet big money doing it. In 2008 alone, Citadel Investment made $1 billion  in profits from its HFT operations.

HFT critics claim these firms simply  suck money out of the market.

Many HFT transactions are made  solely to “sniff out” the market for demand and are withdrawn as quickly as  they are initiated. That’s what gives many HFT firms their lucrative edge.

In fact, as many as 95% of HFT  trades are cancelled, undermining the argument that HFT adds liquidity to the  market.

Experts say the SEC needs to go much  further to have any hope of eliminating the threats that high-frequency trading  poses.

Gilani suggested the SEC implement  filters in the HFT traffic to the exchanges that would slow down opening transactions  but not closing transactions. That would help “close the loop that remains open  in fast-moving markets when new positions are entered, sometimes to knock down  prices to facilitate the vacuum that results in bids evaporating and prices  collapsing.”

Money Morning Global Investing Strategist Martin Hutchinson offered two other solutions.

First, the SEC could introduce a  rule that all orders must be exposed for a full second. That will reduce the  volume of high-frequency trading, but still wouldn’t truly protect  non-computerized outsiders.

The second idea would be to introduce a small “Tobin tax” on all share  transactions. It could be tiny; maybe 0.01%. (The SEC would also need to ban  “exchange rebates” to traders).

“Such a tax would make the worst HFT types unprofitable, without imposing  significant costs on retail investors,” Hutchinson said. “It’s about time the government imposed some taxes to stop the worst of these scams and recover the public some of its  money.”

But until the SEC implements stricter measures, high-frequency trading will keep the markets susceptible to  trading excesses as well as another flash crash.

“We had a lot of change, we had a lot of money, we had no  transparency, and it almost destroyed the financial system of the world,”  former Sen. Ted Kaufman, D-DE, an outspoken critic of HFT, told  the Baltimore  Sun. “I cannot stress enough how worried I am, how concerned I  am about what’s happening to our markets.”

Related: SPDR S&P 500 ETF (NYSEAMEX:SPY), iShares Russell 2000 Index (NYSEAMEX:IWM), SPDR Dow Jones Industrial Average ETF (NYSEAMEX:DIA), Vanguard Total Stock Market ETF (NYSEAMEX:VTI).

Written By David Zeiler From Money Morning

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