Why there is always more than one cockroach

As the Greece/China/Puerto Rice debacles fall from the market’s mind (largely due to postponement of the inevitable rather than a firm conclusion), and as we remain still two months away from a possible first Fed rate hike, the market could be forgiven for pausing for breath.

Step forward the report released yesterday by the illuminary illuminati of the US Treasury, the NY Fed, the Federal Reserve, the SEC and the CFTC [and you need to draw breath after that little list]. Entitled “The US Treasury Market on October 15th 2014“, it does exactly what it says on the tin. This is the in-depth report into exactly how one of the most liquid markets in the world, that of everyone’s favourite flight-to-quality, the US Treasury market, managed to suffer from a completely unprecedented flash crash:

‘Yields continued to trend somewhat lower over the next hour, when they suddenly moved sharply lower just after 9:30am, despite the apparent absence of any news. In the six minutes between 9:33 am ET and 9:39 am ET, the 10-year yield decreased 16 basis points. Between 9:39 am ET and 9:45 am ET, the 10-year yield then abruptly reversed course and nearly retraced the latter move, again with no apparent trigger… For such significant price movements to rapidly occur without a clear catalyst in one of the world’s most liquid markets in such a short period of time is highly unusual

The report is sadly rather non-committal, particularly in its recommendations to just keep monitoring things. But there are some very relevant charts, which point the finger quite definitively at what they term “PTFs” (Proprietary Trading Firms) but what the rest of us would call the machines: the High-Frequency Traders. Check out who was responsible for the spike in volume in both cash and futures over the flash crash in yields (termed the “Event Window”):

Volumes in cash and futures on 10yr Tsys

 

Funnily enough, it’s the Flash Boys. Not necessarily a problem, you might think. Aren’t these guys providing liquidity at all times? The report itself points out that the HFTs kept their bid-ask spreads tighter than banks during this period. But what are they doing with all those bids and offers?

Self trades

Yes that’s right, they are trading with themselves. In other words, their algos are buying back to back with one another; or, they’re putting in bids and then suddenly cancelling them.

And what happens when they try to ram this volume of trades through the trading platforms?

Latency

Latency goes up. Or in other words, the delay in processing all the messages in the system goes up. Note that the x-axis is in 1 millisecond intervals. This sort of thing is happening in massive size, very very quickly indeed.

Now, Blondemoney is no Luddite. Bring on the forces of technological change and let’s embrace it. But it would appear that the market has evolved further than most of its participants can even begin to understand. That means trouble, and not just in a “John Connor let me introduce you to this T1000 guy” kind of a way.

The report concludes that while it may look like markets are now more liquid, they may be more prone to sudden periods of no liquidity:

‘In particular, while liquidity often is high, and, on average, may have benefited from the advent of electronic trading, the changing nature of liquidity provision may have increased the likelihood of periodic episodes of intraday volatility, such as that observed on October 15. That is, as the speed of market activity has increased, substantial variations in market liquidity may have become more frequent than in the past. In addition, the high levels of liquidity observed in recent years have come in an environment of unusually low market volatility and high security supply, which tend to benefit liquidity. Liquidity could naturally be expected to deteriorate somewhat if and when volatility rises.’

Market veterans are used to the concept that the exit door, when required, is usually too small for everyone who wants to get through it. The trouble now is that it is becoming increasingly unclear when the rush to the exit will begin. Likely it’s not when someone has shouted “FIRE!” at an imminent Fed rate hike; but rather when absolutely no-one is looking until they sniff the smoke under their feet.

 

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