Curse of “algo” traders yet again shows regulators need to do more

The curse of “algo” or algorithmic trading – the buying and selling of shares driven by computer programs has come back to haunt the markets yet again with the $440 million loss suffered by US trading house, Knight Capital.

On May 6th 2010, the U.S. Dow Jones Industrials suffered what is now termed ignominiuosly a “Flash Crash”. Within a 5 minute period starting at 2.47pm, the index fell 990 points or 9%, then, in around 90 seconds, the index regained 543 points. At the close, the DOW recovered to be down 347.8 points or 3.2%. The stocks of eight major companies in the S&P 500 fell to one cent per share for a short time and  other stocks such as Apple, and Hewlett-Packard, increased in value to over $100,000. Dow component, Procter & Gamble, dropped over a third before rebounding within minutes, back to near its original levels. If you managed to trade that you’re a genius as well as b&lls of steel!

After a lengthy investigation into the May Crash, the SEC (Securities and Exchange Commission) and the Commodity Futures Trading Commission (CFTC) blamed a large mutual fund firm for selling an unusually large number of E-Mini S&P 500 contracts (75,000 contracts valued at $4.1 billion) as a hedge to an existing equity position. This exhausted available buyers and caused a sudden loss of liquidity and then, high frequency traders (HFT) started aggressive selling so accelerating the effect of the mutual fund’s selling. The HFT’s began to quickly buy and then resell contracts to each other causing the same positions to be passed rapidly back and forth between different companies. In addition, cross-market arbitrageurs who did buy the E-Mini S&P 500, simultaneously sold equivalent amounts in the equities markets.

As a result of the “flash crash”, the SEC put in place new market “circuit-breakers” to temporarily halt trading in stocks that move significantly above or below a reference price. As far as they were concerned they had solved the problem. Maybe not!?

Technical glitches on the day of the Facebook IPO in May had further marred investor confidence in the electronic trading systems of the world’s equity markets. UBS lost $356 million on erroneous trades in the social networking company. BATS Global Markets was also forced to withdraw its IPO in March after experiencing software bugs.

Now we have Knight Capital which yet again showed the apparent fragility of software programs controlling hundreds of millions of dollars of trades. Last week, high speed trader and market maker, Knight, lost $440 million as a result of a software glitch which caused thousands of erroneous trades.  It is estimated that “high-frequency trading”, which includes algorithmic strategies, now accounts for almost half of US stock trading. Knight’s supposedly “fool proof” software was submitting orders for stocks and then buying them back almost instantaneously, with Knight instantly losing the difference in price – not smart!

On Monday, GETCO, Jefferies, Blackstone, Stephens, Stifel Financial and TD Ameritrade injected $400 million into Knight through an issue of preferred shares giving them a 70% stake. The preferred shares can be converted into common stock at $1.50 a share. Assuming full conversion to equity, the new capital will cause Knight’s shares in issue to nearly quadruple from 92.7 million shares to 360.3 million shares, diluting existing shareholders significantly. At yesterday’s closing price of $3.07, there is an immediate 100% profit for those providing the bail out cash.

After Knight’s expensive software glitch it is clear that regulators around the world need to yet again look at the high speed traders and put in place the appropriate controls. Pressure from London and Wall Street firms seems to have yet again watered down any real control on their activities and the Knight debacle has thrown up very clearly that more needs to be done and quickly. Better to over regulate HFT than to leave it to its own devices! 

Contrarian Investor UK