Monday, October 11, 2010

Even Barron's Laughs at SEC's Explanation of Flash Crash

Jim McTague of Barron's magazine wrote an article about the absurdity of the SEC blaming a single "mutual fund complex", aka Waddell & Reed, for the flash crash on May 6.

I thought I got the picture of how the flash crash happened and why, from reading knowledgeable blogsites like Zero Hedge, but there are some new pieces of information in Jim McTague's article I didn't know.

Here's one:

"Twenty thousand trades, totaling 5.5 million shares, were executed at a price 60% or more away from pre-Flash-Crash price levels, and thus later were deemed invalid. At least half those were retail orders."

And here's another, about how the retail investors' orders are handled:

"A brokerage firm will try to match one customer's order with that of another customer in-house. If the firm can't make the trade, it sends the order on to an executing broker. The big ones are Knight Capital, Citadel and UBS. The executing broker will generally take the opposite side of the customer order because retail customers tend to buy high and sell low, so it's easy to make money off them.

"In the rare instances when an executing broker demurs, he sends the trade to a dark pool, usually one owned by his firm. (Dark pools are electronic-trading venues where institutional investors trade stocks away from the public stock exchanges.) If the dark pool can't execute the trade, it is sent to one of the stock exchanges. This largely automated process occurs in sub-seconds.

"On May 6 when the market fell out of bed, the report says blandly, some of these players reduced executions of sell orders but continued to execute buy orders. In other words, they'd sell stock to a retail customer but wouldn't buy stock from a retail customer. They wanted to get rid of their own inventories, not accumulate more shares. So they sent the customer sell orders onto the swamped stock exchanges."

Let me recap the process:

1. Your brokerage firm tries to match your order with that of another customer in-house. If the firm can't match it, it sends your order to one of the executing brokers (Citadel, Knight, etc).

2. The executing broker usually takes the other side of the trade and profit handsomely. But if the executing broker refuses to take the other side, the order goes to a dark pool, usually owned by the executing broker's firm.

3. If there is no trade to be made in the dark pool, the order gets sent to the exchanges.

And so the exchanges were swamped with orders on May 6 when market makers, human or HFT bots, stopped making market.


"Retail stop-loss and market orders were converted to limit orders by internalizers prior to routing to the exchanges. A limit order requires the trade to be executed at a specific price, whereas a market order is the best price available. If the limit order wasn't filled because the stock's price had fallen, it was kicked back to the internalizer who, in turn, set a new, lower limit price and resubmitted it. Orders were kicked back multiple times because prices were collapsing so rapidly. They followed the prices down, "eventually reaching unrealistically low bids," as the report puts it."

And the SEC blames Waddell & Reed for all that.

No wonder the retails have been exiting ever since May 6.


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