Our market regulators are still employing regulatory principles rooted in the 1980s view of the trading environment based on humans wearing multi-colored jackets, while, in fact, what we have is a complex adaptive system of computer algorithms, observed MIT Sloan professor Andrei Kirilenko in his February 7th lecture at Isenberg. An economist with nearly two decades of policy and regulatory experience who most recently served as Chief Economist of the U.S. Commodity Futures Trading Commission, Kirilenko is on a mission to create evidence-based regulatory tools that bear relevance to today's automated trading practices.
In that spirit, Kirilenko walked his audience through his own forensic financial research of automated financial markets to illustrate just how different modern trading practices are from what most people still think they are. Kirilenko began by describing the so-called Flash Crash of May, 6, 2010 - an event that's become a wake-up call for market regulators around the world.
The Flash Crash Dissected. On May 6, 2010, in the course of about 36 minutes starting at 2:32pm ET, U.S. financial markets experienced one of the most turbulent periods in their history. Broad stock market indices - the S&P 500, the Nasdaq 100, and the Russell 2000 - collapsed and rebounded with extraordinary velocity. The Dow Jones Industrial Average (DJIA) experienced the biggest intraday point decline in its entire history. Stock index futures, options, and exchange-traded funds, as well as individual stocks experienced extraordinary price volatility often accompanied by spikes in trading volume.
The event spread through the entire U.S. financial market system with extraordinary velocity and left a broad universe of market participants from professional traders with decades of experience to small retail investors with a realization that something was terribly wrong inside the multitude of automated markets. Calls for stricter regulation or even an outright ban of the so-called high frequency trading (HFT) quickly followed.
On September 30, 2010, the staffs of the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC) issued a report on the events of May 6, 2010. The 104-page report described how an automated execution program to sell 75,000 contracts of the E-Mini S&P 500 futures, algorithmic trading activity, and obscure order submission practices all conspired to create the Flash Crash. The CFTC-SEC report was based in part on the forensic analysis conducted by a team led by Kirilenko at the CFTC and released as a separate research paper for academic peer review.
Kirilenko explained that the analysis shows that contrary to popular belief, HFT did not cause the Flash Crash, but contributed to extraordinary market volatility experienced on May 6, 2010. The analysis also shows how high frequency trading contributes to flash-crash-type events by exploiting short-lived imbalances in market conditions. Based on his findings, Kirilenko argued that while flash-crash-type events temporarily shake the confidence of some market participants, they probably have little impact on the ability of financial markets to allocate resources and risks. These disruptive events, however, raise a broader set of questions about the optimal market structure of and the nature of intermediation in automated markets.
HFTs Reconsidered. Kirilenko showed that there is growing empirical evidence that contrary to some earlier studies, HFTs do not always act as liquidity providers, and that they can supply and demand nearly the same amount of liquidity. Advances in technology and infrastructure have altered the cost-benefit balance in favor of the most technologically advanced financial intermediaries with the smallest overhead per market - the very definition of high frequency traders. As a result, the supply of intermediation services provided by the HFTs has skyrocketed. At the same time, the benefits of intermediation accrue disproportionally to those who possess the technology to take advantage of it. As a result, HFTs have also become the main beneficiaries of intermediation, using it not only to lower their costs, but also to take advantage of the customers who don't have the technology to be able to trade as quickly as they would like to.
Kirilenko concluded his presentation by saying that "regulations for modern automated markets need to be based on evidence rather than outdated philosophies and frameworks." Toward that end, he and his colleagues have began developing what they call Financial Regulation 2.0 - the principles of writing rules for the markets viewed as a complex adaptive system of computer algorithms rather than gesticulating traders of a bygone era.