The SEC/CFTC report on the May 6th "Flash Crash" helps confirm that automated index trading technology was a contributing cause of the 2008 Financial Crisis and why recent financial reforms are not enough to address the ongoing destructive systemic vulnerability that automated index trading technology increasingly poses for financial markets going forward.
- Simply, automated index trading technology inherently makes financial markets much more crash/crisis-prone than less, because it inherently creates disastrously inefficient market outcomes, where in certain conditions, markets can not possibly clear in a fair and orderly manner.
- That's because systemic automated index trading technology by design creates near-instantaneous one-way feedback loops, that when done by enough traders naturally concentrates market momentum in only one direction, creating the disastrous conditions where there is no one else in the market capable or willing to take the other side of all these systemic out-for control automated index trades.
- Regulators and Congress have yet to confront sufficiently the dark side of systemic automated index trading which is highly prone in certain conditions, to create a huge automated "falling-knife-dynamic" which no one can possibly catch on the way down.
- Unfortunately, regulators continue to have a crash-prone bias for maximizing trade transactional speed efficiency, rather than focusing first and foremost on the critical importance of true market efficiency, which is ensuring that markets can clear in an orderly manner and not be manipulated by speculation like automated index trading.
- This regulator blind spot that mass indexing is largely benign, "efficient" and productive, ignores increasing evidence that it is destructive and a predictable recipe for contributing to market failure, like it did in both the Financial Crisis and the Flash Crash.
The regulators "Flash Crash" report was able to pinpoint the spark that exploded the tinderbox of automated indexed markets and that led to an unprecedented near immediate (five minute) trillion dollar fall in market value. The guilty "spark" was purportedly a $4.1b Waddell and Reed automated futures transaction executed without regard to price.
What the Financial Crisis and the Flash Crash teach us is that the greatest strength of information technology, its speed, efficiency and ability to process unimaginable data almost instantaneously, can also be its greatest weakness.
- Our love of technology and the productivity that comes from information technology innovation, combined with how few understand how it all fits together systemically in the financial system, creates a huge and growing blind spot that makes the system increasingly prone to crashes/crises in the future.
- That it took the SEC/CFTC five months to publicly communicate what caused the flash crash indicates how the system is over-driving its headlights on an unfamiliar, dark winding road.
So why does the ever-increasing use of information technology make the market an increasingly explosive tinderbox ready to blow-up from the wrong unanticipated spark?
- At core, all the major trends are concentrating more and more financial resources in the market in fewer and fewer hands, with shorter and shorter time horizons, with more and more automation, and predicated on fewer and fewer core inputs.
- In other words, information technology efficiencies create unprecedented concentration of money flows that now try to pirouette immediately around on an unprecedented concentration of key external variables.
- Simply, more people and more money are betting on fewer and fewer core market variables so the automated efficiencies of information technology are blurring the distinction between the indexing "herd" and the "market" itself.
- The out-of-control use of indexing, means the index herd is a bigger and dumber herd of lemmings that collectively can run off a cliff faster and more efficiently than any supposed market-efficient counter-force that could possibly bring the market into equilibrium.
Think about it. As more and more so-called "investors" put more and more capital into more and more automated index trading schemes that are increasingly immediate, leveraged, and derivative-amplified, the index-herd under certain conditions can become the market itself, when unanticipated developments, like one $4.1b futures S&P index trade on May 6th, could spark the index herd to explode into a mindless automated self-destructive frenzy taking everyone else in the market down with them.
It is worth noting that John Bogle, Vanguard's Founder, and the "father' of index investing, called my 6-11-09 thesis that indexing was one of the root causes of the Financial Crisis -- "nuts."
- I doubt that Mr. Bogle will call the SEC-CFTC joint conclusion in their Flash Crash report, "nuts" too, because the SEC-CFTC determined one index futures trade "spark," mixed in with the tinderbox of other automated index trading programs, led to the Flash Crash of May 6th 2010.
- I also doubt that Mr. Bogle will call Jeffrey Wurgler's recent working paper of the National Bureau of Economic Research, "On the Economic Consequences of Index-Linked Investing, "nuts" because it reaches similar conclusions to my original Precursor research in this series "Indexing into the Ditch."
In sum, my point has long been that indexing and indexers care nothing about market-clearing efficiency, market equilibrium, risk, reward, investment horizon, capital formation, economic growth, value creation, etc. -- that everyone else in the market cares deeply about.
- Indexing is simply a shorthand piggyback arbitrage technique that inherently assumes an indexer always can parasitically benefit more by riding on others backs of non-indexing market participants, because the cost of being a market parasite is less than the cost of being an investment host that cares about risk/reward, capital formation, and economic growth.
- As any doctor will tell you, a living host can survive with few parasites, but if the parasites grow too numerous they steal all the nutrients necessary for the host to live.
At some point in the not too distant future, regulators and Congress will have to confront the unpleasant and increasingly undeniable reality that the capital markets that everyone depends on for capital formation, wealth creation, economic growth and job creation are no longer working as designed and as necessary, but have been hijacked by the mindless lemming herd of automated indexers that somehow all blindly still believe that others can still carry them all to value creation long term.
- Arbitrage can work when a few do it, but not when the arbitrageurs collectively and effectively become the market itself.
Simply, automated index trading programs, if unchecked, predictably will contribute to future financial crises and market crashes, because that is what they are programmed to do.
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Note: Don’t miss Parts I, II, & III of this research series:
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"Systemic Uneconomics -- Financial Crisis Root Causes -- Part III" Click here.
“Systemic Risk Laundering -- Financial Crisis Root Causes -- Part II” Click here.
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“Indexing into the Ditch – Financial Crisis Root Causes – Part I” Click here.
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Scott Cleland is President of Precursor LLC, an industry research and consulting firm, and was the Founding Chairman of the Investorside Research Association. Click here for Cleland's Biography.
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