A Trader's Take on the Aftermath of the Flash Crash

Despite causing a stir among commentators and legislators over high frequency trading, last year's flash crash has not dampened investor confidence in the markets, says Seth Hoenig, the head trader at Glenhill Capital Management. But as high frequency trading continues its expansion into other asset classes - including futures, FX, options and bonds - Hoenig says the risk of another event persists beyond stocks. In an interview with Advanced Trading, Hoenig explains why high frequency trading wasn't the sole cause of the flash crash; why institutional investors need to become more intelligent about market structure, and what his trading desk was thinking as the May 6, 2010 market plunge unfolded.

Are investors confident in the equity markets a year after the flash crash?

Seth Hoenig, Head Trader at Glenhill Capital Management: It's still fresh in everyone's mind and we haven't forgotten about that day. Ironically, funds have seen massive inflows over the past year or so, most notably in higher beta small cap funds in 2011. I don't think that it caused too many people to lose confidence in the market.

As long as regulators can curb extreme periods of volatility, we will be okay. The newly implemented limit up / limit down proposal is a good start. I also believe the volatility halt in the European markets is a good mechanism for market participants to take a step back, and for regulators to determine whether or not there is something functionally wrong with the market. What was unique about May 6 was that we woke up to uncertainty in Greece, so initially one could conclude the massive selloff that day could have been a legitimate move reflecting an event. Regulators need to walk a fine line between becoming too stringent and getting in the way of free markets and price discovery.

How are institutional investors feeling about the marketplace right now?

Hoenig: The institutional side is a little bit different. I'd say smart money is a little bit more risk averse. Both hedge funds and vanilla institutions alike are paying a premium for tail risk hedges as evidenced by elevated implied skew (put volatility richness in relation to call volatility) in the ETFs and some of the indices. Given the macro landscape, world events, and the final weeks of QE2 ending in June, institutions are taking no chances in protecting their portfolios from both macro and market structure risk. Furthermore, as a result of the flash crash, many institutions have to become more intelligent regarding market structure and where they are routing their orders.

As other asset classes become automated, could we experience a flash crash in another market?

Hoenig: Yes, we could. As the market began to sell off, fundamental and opportunistic buyers became exhausted and walked away. High frequency traders began making sales to other HFTs, and in turn created a hot potato effect as these market participants began fighting each other for liquidity. Theoretically, other markets that are fragmented and have a high frequency trading component could be subject to a similar series of events. Recently a Wall Street Journal article noted that because margins and volumes have compressed in equities, HFTs are looking into trading FX and futures. Regulators need to stay on top of this to ensure similar events do not happen in other asset classes. This is certainly not to blame HFT alone. I think many market participants had a hand in what happened a year ago. Algo internalizers that had standing buy orders were not participating on the sharp move lower, and this made matters worse. Unfortunately things happened so quickly there was no way to prevent it at the time.

What was going through your mind as the flash crash unfolded?

Hoenig: We were floored and it was surreal. We have been conditioned in these past ten years to rule out nothing. I remember being in disbelief as to the magnitude of the move in such a short period of time. We were trying to decipher whether or not we were missing information or news, and the move was not reflecting some world event, perhaps with Greece or the EU.

As the Senior Editor of Advanced Trading, Justin Grant plays a key role in steering the magazine's coverage of the latest issues affecting the buy-side trading community. Since joining Advanced Trading in 2010, Grant's news analysis has touched on everything from the latest ... View Full Bio