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High-frequency traders in the cross hairs after stock market's wild day

May 6, 2010 | 11:31 pm

High-frequency-trading firms, which use powerful computers to trade stocks in massive volume, were quickly fingered as key culprits in Thursday’s market debacle.

They’re a natural target, but in fact we may not know who or what to primarily blame until market regulators (hopefully) reconstruct the day’s events.

Still, critics of HFTs, as they’re known, have been warning for more than a year that new computerized trading strategies were dominating the market and leaving it vulnerable to a major shock.

HFTs have surged in number and power in recent years. The firms contend that they bring liquidity to the market. Critics say the HFTs exploit the market with the speed and volume of their orders, and can put stocks at risk of uncontrolled declines -- which is what occurred over a matter of minutes on Thursday.

Dowmay6 As sell orders cascaded and buy orders dried up, non-HFT investors and traders were caught in the day's maelstrom. An investor who had a standing “stop” order with his broker to sell if a stock fell below a certain price -- a way to protect against a severe decline -- might have had that order executed at a drastically low price during the worst of Thursday’s extreme (and short-lived) plunge at about 11:45 a.m. PDT.

Many of those “clearly erroneous” trades will be canceled, but some investors still will end up having sold at prices they will say were ridiculous.

Critics of HFTs also say the firms game the market by being able to sniff out the maximum price at which a buyer or seller is willing to trade. Karl Denninger described the game in a SeekingAlpha blog post last summer.

On Thursday, some HFT firms reportedly stopped trading when the market convulsed. Tradebot Systems Inc., an HFT based in Kansas City, Mo., told the Wall Street Journal that it halted trading “for safety . . . If the market’s weird, we don’t want to compound the problem.”

But as Scott Patterson of the Journal noted, “That appeared to leave investors with fewer traders to take the other side of their orders.”

Veteran traders Sal Arnuk and Joe Saluzzi of Themis Trading in Chatham, N.J., have been vocal critics of HFTs. Late Thursday, Arnuk and Saluzzi put out a statement describing what they believe happened in the market:

We have heard many reasons for today’s market meltdown ranging from a “fat finger” to a program trading error. The issue is not what caused the meltdown, but how the market responded. The market failed today.

The market melted down as bids faded when they saw aggressive selling.

Once that happened, and as there are few requirements to make a two-sided market today, bids were canceled. Market participants were tripping over themselves to exit a market that was in freefall. Leading the tripping was your friendly, liquidity-providing HFT.

Read more from Arnuk and Saluzzi on the jump:

Not so long ago, if our markets experienced severe stress, and certainly a "fat finger," human wisdom would intervene. Reasons for the stress would be ascertained, trading in affected stocks would be slowed or halted, stabilizing bids would be initiated as needed, and severe volatility would be dealt with in a calm and reasoned manner.

Today, the human specialist model has been replaced by an automated market maker model. Our market structure has evolved. It has evolved, not by design or a well-thought and reasoned plan, but it has evolved to cater to masters of expensive technology, deployed unfettered by participants whose only concern is to squeeze out every last picosecond and fractional cent before they move on to other countries’ markets and asset classes. The for-profit exchange model at every turn sacrifices protection of long-term investor interests for the profitability of serving hyper-leveraged intraday speculators.

Today’s price swings in a great number of stocks highlight the inherent and systemic risk of our automated stock market, with few checks and balances in place. This is what we have been warning about for over a year. Once the market sensed stress, the bids were canceled and market sell orders chased prices down to the lowest possible point. Investors who thought they were protecting themselves with the prudent use of stop orders were left with fills that were far away from the closing price. In some stocks like Accenture, this was $0.01. . . .

Today’s severe market drop should never have happened. The U.S. equity market has been hailed as the best, most liquid market in the world. However, today demonstrated that it has major systemic risks built into the system. There was a time today where we didn’t know the true value of a stock. The price discovery process ceased to exist.

Regardless of the source of the liquidity demand, today demonstrated that the liquidity that HFT proponents have always hailed was nowhere to be found. The quest for speed has now caused the loss of confidence in the largest stock market in the world. This is not an isolated incident, it will happen again.

-- Tom Petruno

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