Real-Time Risk: What Investors Should Know About FinTech, High-Frequency Trading, and Flash Crashes (Wiley, 2017) by Irene Aldridge and Steve Krawciw is in large measure an advertisement for AbleMarkets, of which the authors are, respectively, president and CEO. That said, and it is a major caveat, the book provides insight into the often overlooked, or inaccessible, world of market microstructure.
Let’s start with front-running’s cousin, pre-hedging. Front-running is illegal, but pre-hedging or anticipatory hedging, though forbidden on the CME, is allowed in the FX market, and equities regulators allow the use of derivatives to pre-hedge. Let’s say you, a sophisticated trader, place an order to sell shares in IBM (NYSE:IBM). Your broker may buy “put options on IBM before executing your order, with the explicit purpose of protecting itself against your information asymmetry. ….The seemingly innocuous options purchase by the broker has wild ramifications in today’s interconnected markets. Aggressive high-frequency traders … continuously scan markets for arbitrage opportunities and will see the temporal discrepancy between the options activity and the still-lethargic IBM stock (your order still has not hit the markets). The HFTs will take off the price you saw when you placed the order just before your order had a chance to execute,” thereby widening the spread and increasing volatility through the larger bid-ask bounce.
The authors tackle the causes of flash crashes, both market-wide and in individual stocks. Market-wide, they pin the blame primarily on broad-based ETFs such as SPY (NYSE:SPY). According to the law of one price, the basket of securities making up the S&P 500 should have the same price as SPY, and normally stat-arb traders quickly eliminate any disparity in price. But consider the following scenario. An S&P 500 stock falls sharply. Stat-arb traders bring SPY into line. But once SPY’s price falls, “a new force comes to influence the markets, potentially causing widespread contagion among other financial instruments in the markets. This new force is macro arbitrage. … Once the price of the ETF drops, most of the securities in the underlying basket are revalued by the macro traders and algorithms, dragging down the prices of most individual securities in the basket. The basket is now once again priced below the corresponding ETF! Next, the vicious cycle repeats itself.” And “once the flash crash begins in a particular market, it can rapidly spread to other instruments, affecting markets across all asset classes and continents. The recovery can be just as swift: All it takes is for one market participant or system to realize the artificial absurdity in the present crash and the low valuations of the securities to begin to repurchase the underpriced instruments.”
To be able to predict intraday risks one has to understand market microstructure. The authors claim that “in addition to the risks associated with HFT, understanding market microstructure can help predict flash crashes days ahead, minimize slippage when placing trades, and, of course, predict short-term price movements in the markets.” And so, they conclude, “incorporating the market microstructure analytics into financial decisions is no longer an option but a requirement for sound portfolio management.” AbleMarkets is, of course, a market microstructure analytics firm.