We won’t comment much on the carnage from yesterday’s stock market disaster. This may be the time, but this blog is probably not the place. Suffice it to say, if you’re surprised the market could crash like that, it just means you haven’t been paying attention. Ultimately, it’s pretty complicated, but there is a fairly simplified version of it. For a year at least, we’ve figured the boys at Zerohedge probably have best understanding of what’s going on. If you have time for the long version, here’s their take on yesterday.
If you don’t have time for it, the gist of their argument is that High Frequency Traders (HFT), meaning guys with computers, are driving normal investors out of the market, reducing liquidity. To the extreme point that if all those HFT guys get spooked at the same time, chaos erupts.
Predatory market making practices are driving liquidity providers out of the market. Algorithmic systems constantly step in front of displayed liquidity providers, and discourage them from placing passive limit orders. They are programmed to automatically step in front of displayed limit orders, to be at the front of the line for execution. This practice is especially prevalent in thinner stocks. If a human trader places an order at $20.05, the algorithmic system automatically bids $20.06. If the human raises their bid to $20.07, the computer goes to $20.08. This discourages true liquidity providers, and they place less passive limit orders.