Fingers don't get that fat. Error, Manipulation or Cyberattack?

Call me a paranoid old nerd, but the "fat finger" explanation for the 1000 point drop in the US stock market on Thursday just doesn't make any sense.

When I ran $6B in quant equities as an institutional manager in the 90s, we had multiple redundant layers of checks and checks-on-checks to avoid that kind of error. The early "electronic order working" systems (high frequency trading when frequencies weren't as high) had their own safeties. Additional layers were in place at the receiving end, at the brokers and the market centers.

There were stories of temp employees or traders coming back after a liquid lunch and offering to sell 900,000 shares of a stock at 1000 yen instead of 1000 shares at 900,000 yen, and getting whacked, but they didn't crash the market. (Things can be more extreme in Japan - there are no $900,000 US stocks.)

Legitimate traders who make these errors fess up fast, and work with the guys at the other end to tweak the filters so there are no encores. No one is stepping up on this one. (Added 5/9: Theory B is that there is a programmer with soiled trousers hiding in a Chicago basement who is too petrified to tell the management, who would report.)

So what happened? Maybe a market manipulation. Always a good way to make a lot of money in a hurry. There's an old (and very funny) novel called "Green Monday", by Michael Thomas, that tells a similar tale. It's been out of print for 29 years, but can be had on Amazon for $0.01 (plus five bucks shipping). It tells the story of a down-in-the-royal-weeds lower level Saudi prince who gets no respect as a garden variety  multi-millionaire and wants to impress the family by making himself a mega-multi-billionaire. He goes to a thinly disguised version of BARRA (an early quant firm), where the Certified Neologic Investment Theorists (who take great pride in bragging "I am a fully certified NIT!") design a program trade to rapidly take and then rapidly unwind positions in stocks that would have large price moves after a manufactured oil shock engineered by the upwardly mobile junior prince, moving him up to the major leagues of prince-dom. Today, fast turns in leveraged index futures and options would be a turbocharged version.

It was remarkably prescient. Electronic trading was in its infancy - the NYSE DOT system, designed to free brokers from the annoying 100 share orders was only five years old when the novel was published. But then, as now, pump enough of those 100 share orders through the computer and pretty soon you're talking serious money.  Back then only a small percentage of stock and futures transactions were done electronically. Today, it's approaching 100%.  It good to hear that the SEC seems to be on the case, with the old Watergate mantra of "Follow the money". Maybe we'll know more next week.

A scarier explanation it that this was a test run for a potential cyber attack on US financial systems. Remember Richard A. Clarke, a career civil servant who was chief of counter-terrorism at the National Security Council in the last years of the Clinton administration and the first years of Bush 43? He spent most of 2000 warning about trouble from that tall wacko Osama bin Laden. And being ignored.

Clarke ended his long government career in 2003 and is now warning of a new threat, Cyber attacks on our information infrastructure - electrical, water, communications and, yep, financial systems.

He documents some truly knee-trembling events that look like probe attacks. Bad enough to be visible to the perpetrators, but not so dreadful that we were all stuck in elevators in the dark.  What happened on Thursday is eerily similar to the attacks he describes. If so, it may indeed be time to move the portfolio into canned goods, ammunition and tequila. And to hope the NSA and the nascent Pentagon Cyber Command  are on the case along with the SEC, who would be way out of their depth on this.

Let's hope this was plain old greed, and not a test run for a Weapon of Mass Financial Destruction.

[Update 5/9 - Stories about Thursday's events are starting to include names of firms that might have been involved. A good sign, but there are still no definitive answers. Comments to the effect that this was a complex interaction of multiple HF trading systems across fragmented equity market centers raise the question of why this hasn't happened before. HF trading and sweep orders have been in wide use for years, and Thursday's trading before the event was unusual, but not in any extreme way. 

I hope that this was an innocent accident. However, even if this was the case, it suggests that it could be repeated for less-than-innocent motives. During the cold war, the strategic goals of the US were Stability and Security. A good motto for modern markets as well.]

[Update 5/11 - From yesterdays WSJ story: "Tradebot Systems Inc., stopped trading to limit its losses. Other high-speed firms also pulled back. These firms typically buy and sell when other investors need to trade, so their withdrawal could have primed the market for a fall.

Around the same time, the big P&G sell order hit the NYSE floor. It is not clear where the sell order came from and how big the order was. It overwhelmed available buy orders, traders say. "

How can this happen? Are anonymous channels open into the equity trading system?]

Comments

[Tom Chechatka]

I am wondering whether the "fat finger" was a "reaction" to Senators Cantwell and McCain introducing an amendment on Thursday aiming to restore safeguards modeled on the 1933 Glass-Steagall Act to the banking and financial reform legislation currently being debated in the U.S. Senate.

http://cantwell.senate.gov/news/record.cfm?id=324753

Most curious is the fact that, squarely in the eye of Thursday's market hurricane were Proctor & Gamble and 3M. It hardly seems the fate of these two companies hinges on events unfolding in the Euro-zone. Likewise, the trans-Atlantic banking system could suffer a spectacular collapse and both companies would no doubt survive.

Points you raise regarding the "who" and the "how" are informative and very much appreciated. The "why" might help isolate possibilities. That PG and MMM were targeted seems to make the "why" glaringly obvious.

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[Scott C]

The crash is most likely a chain effect of quant trading systems. There's 100x more capital following quant portfolio strategies than high frequency trading. The portfolios are constantly rehedging themselves.

The $4billion order by Waddell & Reed is not that big at all for the s&p future. There are hedge funds that trade that size everyday.

Perhaps a manipulator pushed the market until they snapped all the market makers 'rubber band' and they had to cover, causing an overshoot, but I don't think anyone with the kind of money to make that happen to the SPX future would risk regulator attention.

The SEC needs to be restructured. Elliot Spitzer with a staff of 5 in New York did more effectively policing of the markets by having a nose for good tipoffs than the SEC did with a staff of 4,000. Harry Markopolos was pounding on the SEC door with a sledge hammer and they couldn't hear it.

You've got to update this blog a bit more often.

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