FINANCIAL TSUNAMI IN THE MAKING

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One Of The Biggest High Frequenecy Traders Warns Of Potential Market "Catastrophe"
02/04/2016

Back in April 2009, we wrote what may be the first seminal article predicting the failure of capital markets as a result of widespread predatory high frequency trading and fragmented market structure when we laid out "The Incredibly Shrinking Market Liquidity, Or The Upcoming Black Swan Of Black Swans." Several years later, and countless flash crashes, we have been proven right, however one thing is missing: "the catastrophe" that finally wakes up people to the dangers of all the individual things we have warned about over the years.

Today, we are one step closer to that day, when none other than the head of one of the biggest high-frequency trading companies, Mark Gorton of Tower Research, warned that there are several faultlines in the structure of increasingly electronic, automated financial markets that could lead to a “catastrophe” in the long run, according to the FT.

To be sure, Mark Gorton, has a clear conflict of interest: being one of the largest HFT members himself, with his company dominating program trading on the NYSE with his Latour Trading subsiiary, the founder and head of Tower Research Capital argued that exchanges have become far more efficient with the advent of more computerised markets, but "cautioned that increasing complexity brought new dangers that needed to be mitigated."

In other words, don't blame the HFTs, blame the markets, which is to be expected from a person who will be out of a job if HFT is banned.

He further adds that "The recent evolution of markets from manual to electronic trading has had huge benefits and investors save money every day due to the lower cost of trading. But electronic trading brings with it a number of new risks, and we need to continue to strengthen the resiliency of electronic markets," Mr Gorton told the Financial Times.

What keeps Gorton up at night? The short answer: the lack of safeguards at exchanges to prevent HFT firms like his from dragging the whole thing down:

The high-frequency trader is particularly concerned over the lack of risk controls at exchanges, which he said constituted a “large hole in the middle of the system that needs to be filled”.

HFT outfits and investment groups that use algorithmic strategies say they have a latticework of different safeguards to prevent ultra-fast computerised strategies from running haywire, which has been further reinforced after one high-profile market maker, Knight Capital, imploded in 2012 after losing $10m a minute in a 45-minute electronic trading rampage.

Regulators and bourses such as the New York Stock Exchange and Nasdaq have introduced a clutch of reforms and firebreaks in recent years — especially in the wake of a “flash crash” in 2010 that underscored how automated markets have become — such as circuit-breakers when stocks or markets fall by a certain amount.

Nonetheless, exchange-level risk controls remain “limited at best” and should assume there will inevitably be glitches, bugs and errant trading algorithms that could cause problems in the wider market, according to Mr Gorton.

Glitches from algorithms, he forgot to add, such as the one Tower uses each and every day to scalp and frontrun billions of trades in order flow.

However, his warning, conflicted as it is, is spot on: the market will crash again, it is only a matter of time, simply because the HFTs have captured market regulators so well, nobody has any idea what is going on any more: “We need a regulatory framework that assumes that any single system in the market will fail and insures that we have multiple redundant levels of checks that can catch failures in other parts of the system,” he said.

What is Gorton's suggestion?

Mr Gorton highlighted in particular the lack of a centralised position-tracking mechanism for the US stock market, the need to refine and synchronise market circuit-breakers between highly correlated markets, such as cash equities and futures, and the absence of clarity over what it takes for trades to be declared invalid.

In other words, focus on the symptoms, shutting down markets when things go haywire, not the underlying cause, which as we have said since 2009 is simple: broken markets, designed to benefit just one group of traders.

Exchanges can in certain cases cancel trades when there is “clearly erroneous execution”. Usually this happens automatically when someone tries to trade at a clearly illogical price, but bourses are given more latitude in times of extreme turbulence.

For HFT that help make markets by trading constantly at lightning speed, that can be problematic as it “creates a situation where market participants are forced to pull back during times of extreme stress due to uncertainty about their positions due to potential trade breaks, and this weakness can contribute to a crash in the future”, Mr Gorton said.

While electronic, computer-driven markets have been a boon to investors, some of these holes should be addressed, the former Credit Suisse trader and electrical engineer said.

“We’re creeping in the right direction, but unless we proactively address these issues, sometime in the next several decades we are going to experience a catastrophe due to runaway computerised trading,” Mr Gorton said.

One question remains, the biggest one: why come public with this warning, which even the most naive traders can between the lines on? The answer is simple - as we have predicted long before the Sarao debacle, once the next big crash happens, everyone will be looking for the scapegoat, and one will be readily available: the same market parasites who have long abused the broken market on the way up, getting rich beyond their wildest dreams, will be those blamed for everything that went wrong on the way down, if only to deflect from the farce that central bankers have unleashed upon capital markets: the High Frequency Traders. And judging by this FT piece, they now know it very well...

http://www.zerohedge.com/news/2016-02-04/one-biggest-high-frequenecy-traders-warns-potential-market-catastrophe