Hull Warns of HFT Cancellations & the Illusion of Liquidity

Include Blair Hull, founder of Ketchum Trading, among those who are concerned about the consequences of high-frequency trading, about what he calls the “illusion of liquidity” that it substitutes for the real thing, and among those who has definite ideas as to what the authorities might do about it.

Hull is renowned for buffering the Black Monday crash of 1987. He was buying, and thus restoring liquidity at the bottom, the following day (October 20). In 2005, Trader Monthly compiled a list of “the 40 greatest trades of all time,” and put Hull’s purchases in the MMI pit that October as the 17th greatest.

Hull addressed The Trading Show Chicago 2012 on June 24, 2012 on this topic: “Examining the Revolution – How Technology is Changing the Trading Landscape.”

Trading and Computers

After a preliminary discussion of blackjack, Hull moved to the tangled history of technology on the trading floors. He reminded his audience that it wasn’t until 1981 that they could actually write a FORTRAN program to access real-time prices. As late as 1985 exchanges still prevented traders from even having computers on the floor. The irony of course is that the old-fashioned “floors” have nearly disappeared by 2012, and exchanges now, in essence, are computers.

He comes in this way to that 1987 crash. On October 19th, fear took over the trading process and “prices moved almost as if there were no buyers.” Why? Because the portfolio insurance company, LOR, had unwittingly managed to substitute the illusion of liquidity for its reality. Their computers were programmed in a way that assumed that one could sell futures at any necessary price.

Rubinstein, the “R” in LOR, was a professor at Berkeley, Hull recalled. Soon after the crash, the two men met at a social event and Rubinstein confessed, “I think I caused the crash.” He was one of the first to reach that conclusion, and he was right.

Hull, as if to remind us he isn’t against technology, also spoke of how during his time on the CBOE board in the late 1980s he was the “least popular member” there, precisely because he pressed to automate trading. He seems still ticked off that his warnings were unheeded, and that ICE stole a march on the Chicagoans there.

Where We Are Today

In bringing his remarks into the 21st century, Hull gives a shout-out to Scott Patterson’s book, Dark Pools. This book describes, in Hull’s summary, that traders around the country “took the game away from New York,” and in the process invented high-frequency trading. Despite its name, HFT isn’t really about speed. It is about queue position and ordering, and thus about cancelling.

In the process of taking the game away from New York, these bright and ambitious traders and technologists were making queue position even more important in trading than price. Here Hull moves into a discussion of Reg. NMS. It is “extremely complicated” but one of the provisions is the order protection rule. Reg NMS was “a tremendous gift to HFT,” and its unintended consequences led to the creation of both  Direct Edge and BATS.

The Flash Crash and Since

From: Blair Hull’s presentation, Chicago Trading Show

The graph above shows the flash crash of May 2010. The impressive chasm near the day’s end occupies only about ten minutes: four minutes on the way down, six minutes coming back up. If the fall had come at the day’s end, if there had been no time for a recovery, there might well have been more serious macro consequences.

The real problem, Hull says, is that again as in 1987 (in a different way of course) traders were working within a market structure that allowed “the illusion of liquidity” to displace the real thing. He cites an authority, because as he says his firm, Ketchum, likes to stay close to the academic literature. The academic authority is Ananth Madhavan, the article “Exchange-Traded Funds, Market Structure and the Flash Crash.” Hull quotes Madhavan saying “Our results show the Flash Crash can be linked directly to current market structure.”

From: Blair Hull’s presentation, Chicago Trading Show

Hull recommended that the authorities do three things: allow a zero spread; designate a minimum order life; charge for cancels.

As his presentation drew to a close, Hull mentioned briefly microwave technology, which will still further quicken the pace of events in trading. See above graph for the scale of the change

His conclusion, though, was that the SEC could make the business of trading more fair and more stable “if they really understood the problems.”

Be Sociable, Share!

One Comment

  1. Blair Hull
    October 17, 2012 at 9:11 pm

    Nice Summary of what I said:

    The real issue is “How do we prevent another “Flash Crash”?

    1. Allow locked markets
    2. Minimum Order LIfe. 50 milliseconds
    2. Charge for cancels not for transactions

    Blair Hull

Leave A Reply

← BCG: Private Banking Will Get More Complicated Pension Reform: It’s Not Just About Delaying Retirement →