Posted by John Bates
At the CFTC's first Technology Advisory Council meeting on July 14, there was concern expressed around the concept of quote-stuffing. There was some evidence presented that the May 6th flash crash may have been caused by or exacerbated by this activity. While with regard to the flashcrash, other market experts I’ve spoken to know dispute this was the cause, quote-stuffing is a topic worthy of discussion
At the CFTC meeting, where I was an invited participant, data was presented from trade database development firm Nanex, which suggested quote stuffing contributed to the destabilization on May 6th. In this case the data suggests huge numbers of quotes were fired into the market on particular symbols (as many as 5000 per second) and that many of these were outside the national best bid/offer (NBBO). So what’s the point of this? Well with latency as a key weapon, one possibility is that the generating traders can ignore these quotes while the rest of the market has to process and respond to them – giving an advantage to the initiator. Even more cynically one can consider these quotes misleading or even destabilizing the market. In fact, Nanex state in their paper: "What we discovered was a manipulative device with destabilizing effect". Quote stuffing may be innocent or an honest mistake, but Nanex's graphs tell a very interesting tale (http://www.nanex.net/FlashCrash/CCircleDay.html). There are patterns detected - on a regular basis - that one could conclude is quote stuffing for the purpose of market manipulation. There's a very good article by Alexis Madrigal that discusses the research and issues in more detail (http://www.theatlantic.com/science/archive/2010/08/market-data-firm-spots-the-tracks-of-bizarre-robot-traders/60829/).
At the extreme, quote-stuffing could operate like a “denial of service attack” – firing so many orders that the market can’t cope - and crippling the trading of certain symbols, certain exchanges or the whole market. An influx of orders in sudden bursts to one exchange on one stock can slow down that system as it tries to process these orders. Nanex notes that there are 4,000 stocks listed on the NYSE and nine other reporting exchanges in the U.S. If each reporting exchange for each stock quoted at 5,000 quotes per second it would equal 180.0 million quotes per second. A daunting task no matter how advanced their processing technology is.
Without trying to overstate the issue, in the most extreme circumstances these practices could be considered algorithmic terrorism. One can imagine how, at the extreme, it is potentially catastrophic. The concern is that a well-funded terrorist organization might use such tactics in the future to manipulate or cripple the market. So much of our economy is underpinned by electronic trading – so protecting the market is more important than guarding Fort Knox! Regulators, such as the CFTC and SEC are taking this seriously - and need to respond.