By Numerian

Dig deep enough into any financial crash and you will find leverage – someone, somewhere has borrowed money to invest in the asset in speculation. In the US stock market crash of 1929, the main culprit was margin. Investors were allowed by their broker to buy shares with money borrowed from the broker, and to buy more shares with the profits on their existing shares. When prices peaked and began to fall, the brokers discovered their customers no longer had enough value in their shares to cover the loan to the broker, so they issued a “margin call”. If the customer couldn’t come up with more pure cash to restore a positive collateral value for the broker’s loan (and many couldn’t), the shares were sold and the loan repaid. As customer after customer faced margin calls, shares were pressured lower and lower, and hence the cascading price decline known as a market crash.

Margin is strictly limited for retail customers in the US, but not for banks, hedge funds or other big players. Moreover, these investors can use futures and options to increase their leverage, since you typically spend 2% of the face value of the contract to control that amount of money. This is one of the lessons learned from the 1987 stock market crash in the US – still a record loss at nearly 22% in one day. Options played a pivotal role in this crash, because an option product called portfolio insurance prompted investors to sell ever-increasing amounts of stock to maintain a hedged position in their option portfolio.

We can make a reasonable assumption that leverage was a contributing factor to the “Flash Crash” event last Thursday in the US stock market. Another obvious place for leverage to creep into the system is through futures and options purchased by the “algos”, the algorithmic models that operate on pre-programmed instructions to buy or sell equities or their derivatives if certain levels in the market are broken. As each successive support level was broken on Thursday, an increasing number of futures and options flooded the market, exacerbating the selling pressure similar to the portfolio insurance disaster of 1987.

Except this time the results were worse. At least in 1987 there were humans on the floor of the exchange required to post bids and offers, no matter how wide, to support the market in times of disruption. These “specialists” have long since been replaced on the floor of the New York Stock Exchange by computers, and both the NYSE and NASDAQ now carry only 35% of the total market volume vs. all of it ten years ago. The rest is handled by satellite exchanges with names like Archipelago, which have no requirements to support the market in times of stress, and which make the regular exchange protections useless.

This is why the 20 minute collapse of the market last week was much scarier than the 1987 crash. At least back then it took all day to work through a 20% drop in value; here you could watch the crash unfold in less than half an hour, thinking all along “where will this end?” It didn’t take any imagination for people to extrapolate and realize in the remaining hour of trading the market could easily lose half its value.

Making this situation eerie and frightening was the sense that there were no humans involved in what was transpiring. Computers were getting price feedback from the market, the prices themselves being dictated by other computers forced to sell at pre-determined levels. One algorithmic program after another was triggered into issuing sell orders, with none programmed to buy in any significant way. The result was 20 to 50 point drops in the Dow occurring in sickening succession with no pause for breath, because computers don’t need to breathe. No wonder the news reporter Brian Williams said it reminded him of 9/11.

The Flash Crash therefore had one critical feature – the use of leverage by high volume players – combined with a new, modern feature – abdication of responsibility for trading to computers and out of the hands of humans. The 1929 and 1987 crashes can now occur in a fraction of the time and with potentially greater damage.

The initial reaction of traders to the Flash Crash was that some human must have made a mistake submitting a trade. But the SEC has investigated the different ways in which trades can be submitted erroneously and hasn’t found evidence of a “Fat Fingered Louie” punching a billion rather than a million on an order. In fact, the SEC still doesn’t know what caused this crash.

Curiously, no one is focusing on what caused the crash to stop. There were however some heroes of the day which can be identified on the tape recordings of the event. Out in Chicago on the Board of Trade’s S&P 500 futures pit, you can hear the traders suddenly calling out that JP Morgan and Merrill Lynch were big buyers precisely as the market hit minus one thousand points on the Dow.

It seems rather odd that both these firms at the same time would see the same trading opportunity. In fact, what they did was violate one of the prime rules of trading: never try to catch a falling knife. The market was falling fast and furious at the point they entered the pit to buy equity futures, so why did they take such an enormous risk? We learned yesterday that both of these firms, plus Goldman Sachs, were such superb traders in the market that none of them had a single losing trading day all last quarter. This type of risky trade is not how you get to be a superb trader.

First, we have to realize how preposterous it is that anyone describing themselves as a trader could possibly claim to have day after day of prosperous trading for an entire quarter. Usually you are lucky as a trader if fewer than 45% of your trades are losers, so the statistical odds of this happening for any trader are virtually impossible. What has been going on in the “trading rooms” of JP Morgan, Merrill Lynch and Goldman Sachs isn’t really trading, but something entirely different that guarantees them a daily profit.

That profit can come about by borrowing money from the Fed at 0% (they are the only ones in the nation with access to this favorable rate at the central bank), and then investing it at 3.5% in Treasuries. This little scam, in which the Fed transfers wealth from those in the US who have actually saved money (mostly retired people) to the big banks, is risk free money for the banks because the Fed has promised this game will go on for “an extended period.”

These big banks can also profit from handling the Fed’s purchases in the past year of Fannie Mae and Freddie Mac mortgage backed securities, with the banks able to nick a fee on each security that passes through their account to the Fed. But for our purposes the really interesting guaranteed profit comes from the High Frequency Trading done by these banks. This HFT business is just another name for algorithmic trading by computer, but it signifies that the banks have direct access to the New York Stock Exchange computers and can see all sorts of interesting information. If you are an investor who has put in an order to buy or sell shares, the banks see this first before the order is executed. They can and do enter their own orders at a milli-penny price difference to prevent you from getting the best price on the exchange. They can also see all stop-loss orders, submitted by investors who want to protect themselves in the event of a market decline.

There are a number of other firms, not just banks, which have HFT privileges, and they are all part of the “algo” universe traders talk about more and more, because these firms represent three-quarters of all daily trading volume, and they have shown an ability to control market direction. It was the algo firms that pushed the stock market up to new 52 week highs with a relentless drive from the February lows. The market had rarely seen such consistent buying orders coming in by computer any time the market touched the five day moving average, nor had it seen such a string of up days with so few down days, lasting months on end. By the time the markets had reached their peak in April, everyone knew the only way to make money was to buy the market. There were no short positions left in the market because of the risk of loss, and options buyers owned an overwhelming number of calls compared to puts, because only calls made any money for investors.

Someone in the algo universe not only contributed to this peculiar rally, but knew where all the stop losses were for investors who wanted to protect themselves should the rally reverse. Someone also knew that from the price low in February up to the April high, was a massive “air pocket” in which there were no natural buyers for stocks and therefore no real support. The market could easily be manipulated into a crash if the stop losses could be triggered, especially given all the leverage in the market (the huge number of option calls outstanding represented a leverage hot point alone). The Flash Crash in fact pushed prices all the way down to the February lows, right through the air pocket, in the space of 20 minutes.

Was this crash manipulated? The SEC announced yesterday that it is subpoenaing the trading records of a number of players it did not identify. Could the big banks have been involved in creating the crash? Possibly, but an equally plausible argument for some of them being the heroes and reversing the crash could be that JP Morgan and Merrill Lynch had balls of steel to run the huge risk they did. More specifically, they could have been temporarily lent those balls of steel by someone who really does possess them – Timothy Geithner, Secretary of the Treasury, who has access to billions of dollars of taxpayer money useful in stopping market crashes. Perhaps the Treasury was using these banks as part of a Plunge Protection Team directive. Quite a few traders suspect so, partly because neither the SEC nor anyone else is looking into how the crash reversed course, and there seems to be an awful lot of misdirection away from this question.

If there was a manipulator, it could also have been any number of other HFTs not located on Wall Street. Such a manipulator could also have chosen minus 1,000 points on the Dow as the place to start buying back their short positions. You remember in the movie Trading Places even Louis Winthorpe III and Billy Ray Valentine had to buy their trades back at some arbitrary point when the market seemed most desperate to sell. Was the Flash Crash a manipulation straight out of the movies, as cheesy as this sounds?

We can only hope so. We can only hope that some perpetrator is clearly identified and brought to justice – severe justice, preferably – because the situation we have now is much, much worse. What we know now is that the SEC can’t identify the cause of the Flash Crash, and is not interested in the correction that followed. All the government can tell us is that they are looking into things, and recommending that more circuit breakers be installed on the NYSE and NASDAQ, and for the first time on the satellite exchanges.

This is the Kindergarten approach to regulation: tell the market to take half hour or one hour time outs when things get out of hand. This is the best the government can do, because it doesn’t know what went wrong, and it hasn’t any idea how to neutralize the fatal brew of leverage and computerized trading.

One other thing the government recommends: if you are an individual investor, use stop loss limits rather than stop loss markets to protect yourself from market declines. This bit of technical advice says an investor when submitting a stop loss should identify a particular price at which the loss must be executed, rather than leave it up to the broker to find any price – no matter how bad – once the stop level is breached. Some investors who bought shares of a stock like Accenture (the old Arthur Andersen consulting arm) were forced to sell at prices close to one penny.

We should contemplate what this means. There were some investors who lost the entire value of their equity holdings in this Flash Crash. We don’t know if this means they were wiped out financially and forced into bankruptcy, but it is bad enough thinking that even one of their equity holdings was stolen from them by some HFT which bought them for pennies on the dollar. We know there were tens of thousands of investors who took some loss, not necessarily as catastrophic, as their stop loss levels were hit. We know a handful of investors were smart enough to be short the market before the crash, and who bought back their shares in the middle of it, only to have the NASDAQ invalidate their trades capriciously. The NASDAQ decided to disallow over 10,000 trades done within a 20 minute time period last Thursday, if the price was more than 60% away from the day’s opening price. Even the NASDAQ admits that the 60% level was set as a compromise among board members who wanted 50% while others wanted 70% as the threshold. The NYSE, by the way, has not invalidated its trades.

Putting all this together, it is no surprise that individual investors have nothing but distrust and disgust for the American stock market. The stock market seems to be nothing but a playground for the big banks and other connected firms who get a preview peek at everything that goes through the market, and who can program their computers to skim profits off daily with no risk whatever. The stock market is also, quite possibly, prone to more serious manipulation that resulted in last Thursday’s crash. The regulators are clueless and helpless to do anything about this situation, at least so far.

At the moment, individual investors are wise to follow the advice of Reuters columnist Felix Salmon, who urged the small investor to get out of the market now before it is too late. For the individual investor, the stock market is dysfunctional and dangerous.

This situation is not only dangerous for the individual investor, it is dangerous for the US economy. It means companies have lost one of the principal means of raising fresh capital, and it means investors have lost a means of investing in equities on a fair basis, knowing that the price they get for buying or selling is reasonably derived and not artificially determined.

Investors all around the world are facing up to the fact that the American stock markets are badly broken and not a safe place to put your money. Any rallies that occur on the these markets are very possibly artificially created, like the rally we saw from the February lows, which took three months to build but was wiped out in 20 minutes. Any stock you own on this market is prone to suffer catastrophic losses and possibly be stolen from you outright in a market crash. Any protection you place in the form of a stop loss is useless in times of market stress. Any trade you execute in a time of market stress is liable to be canceled on you by the exchange itself.

In short, the message to investors everywhere is to stay as far away from Wall Street as possible.