Dust flux, Vostok ice core

Dust flux, Vostok ice core
Two dimensional phase space reconstruction of dust flux from the Vostok core over the period 186-4 ka using the time derivative method. Dust flux on the x-axis, rate of change is on the y-axis. From Gipp (2001).

Tuesday, August 9, 2011

Flash crash: business model or indicator?

After the series on deconstructing algos, a few things become clear:

1) HFT, by and large, does not increase liquidity. On the contrary, it works by reducing liquidity at key intervals (during periods of determined buying or selling), resulting in larger price moves than would otherwise be the case.

2) We can distinguish between the brief episodes when an algo clears out those pesky human bids from those when two algos are going toe-to-toe in a stat arb war, as well as those intervals when an algo is taking some hapless mutual or pension fund to the cleaners.

Examples below are accessible through here, except for the first one which was posted here.

Eliminating human bids before the fun begins--2 s.

Scalping the fund by removing liquidity in the face of determined buyingNote the sudden
 rapid rise in stock price while the fund buys, and the price returns to normal afterward.

Two algos slugging it out. Notice a lot of activity in the bid/ask but very few trades actually occur.

Two algos duel. Then, at 10:25, a committed buyer shows up for a scalping.

A committed seller experiences HFT (note the rapid decline in price).

The flash crashes occur because somebody needs to sell a quantity of shares. The algos "perceive" the orders coming to market and choke off liquidity, and the seller gets a poor price.

The flash "rises" occur because somebody needs to buy. In response to demand, the algos again remove liquidity.

In neither case is liquidity being offered when it is needed. In fact, the exact opposite is occurring. By systematically removing liquidity when it is needed most, HFT algos destabilize the system. This destabilization is merely a side effect--the algos increase the profits of the companies that operate them. But this is very much like the Enron method of doing business--shut down plants at a time of soaring electricity demand to line your own pockets while possibly bringing down the electrical network.

Days with a lot of flash crashes, as on Friday (August 5), are days where there is a lot of institutional selling. It is possible that the focussed withdrawal of liquidity by these service providers contributed to the rather steep decline of the indices on that day.

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