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The Morning After the Crash


Wall Street is still trying to figure out why the Dow lost 1,000 points.

The biggest question this morning is: What caused the US stock market to erase more than $1 trillion in market value as the DJIA fell 9.2% in less than 20 minutes?

The major media picked up a story that a Citigroup (C) "fat fingered" an order for S&P 500 emini futures contracts. According to Bloomberg, after the close Thursday night, Citigroup said it had "no evidence" that it placed erroneous trades. Meanwhile, in a statement released Thursday, the CME Group (CME) said that Citi's activity in the futures market didn't appear to be irregular.

It's not very likely that a "fat finger" trade alone caused the large drop in the US stock market yesterday. If that did happen, there should have been enough liquidity to support the market. There's a good chance that the drop in yesterday's market was due to High-Frequency Trading (HFT).

An article by Dennis Dick from Bright Trading is being passed around on Wall Street today. According to Dick, predator market making, which is a form of high-frequency trading, drives liquidity providers out of the market by using an algorithmic system that steps in front of liquidity providers' limit orders. Dick believes that these predatory market making systems are having disastrous effects on the liquidity in the market. He said, "As true liquidity providers become more discouraged, and place less passive limit orders, the depth of the market gets thinner. Therefore, when we have a trader with a 'fat finger' accidentally make a mistake, there are less liquidity providers to cushion the blow."

So it could be that a trader did accidentally have a fat finger, however, there was just not enough liquidity in the market to handle the move. This then caused all of the quant traders' computer programs to rush from one side of the boat to the other, causing it to capsize.

However, Scott Patterson from the Wall Street Journal wrote that many high-frequency trading firms actually stopped trading during Thursday's sell-off. He believes that high-frequency trading actually provides liquidity, so when the HFT firms stopped trading, it added to the downturn.

What can be done to fix the obvious flaws in the market? Senator Ted Kaufman, of Delaware, who has been a big proponent of HFT, released a statement yesterday saying that regulators need a better understanding of high-frequency trading. In his statement, he said, "The battle of the algorithms -- not understood by nor even remotely transparent to the Securities and Exchange Commission -- simply must be carefully reviewed and placed within a meaningful regulatory framework soon."

It's still unclear what caused yesterday's sell-off -- an erroneous trade, too many computers trading at the same -- but by the time we find out, the financial world will have moved on to bigger problems. What we do know is that it's not normal for a market to drop 5% in 20 minutes and then regain its losses 10 minutes later. Then again, these are not normal times.

How to Play It:

As I write, Bloomberg is reporting that the Bank of Japan said it's pumping 2 trillion yen ($21.8 billion) into the financial system to help stabilize the market. As of right now, it looks to be working: The USD/JPY is up 2.19% while the EUR/USD is up 1.12% and S&P 500 futures are up 0.90% to 1132.75.

Just like 2008, I'd suggest watching right now. The market is moving too fast for non-professional traders. To show some of the ludicrous prints from yesterday's crash, check out these charts of Apple (AAPL), 3M (MMM), and Procter & Gamble (PG) as they are some of the biggest companies in the S&P 500.

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Here at Minyanville we always try to provide the best coverage of Wall Street and yesterday's crisis was no exception. Here are the views of some of our professors: Todd Harrison, Michael Davis, Jeff Macke, Yaron Sadan, and of course many more live comments on the Buzz and Banter.
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