High frequency trading combined with a complex market structure leads to crazy anomalies on an almost daily basis. This past week we saw an entire market shut down as the Nasdaq went offline for more than three hours. This scenario was a bit more complicated than the BATS outage because Nasdaq is responsible for disseminating prices of certain stocks (and their quotes) to all market participants via an information feed known as the Securities Information Processor. The SIP is a critical piece of information for traders. Often referred to as “the tape” this is essentially what the majority of regular folks see when looking at prices and quotes for stocks, or what you see on the bottom of the screen on CNBC. The description from the gentlemen at Themis Trading is rather succinct.
The SIP is one of the most important and least understood pieces of our equity market. It aggregates all of those fragmented exchanges and distributes the NBBO (national best bid and offer). The NBBO is what all those dark pools use to price their merchandise and also what all those internalizers rely on to give sub penny price improvement. The SIP is the hub and the exchanges are the spokes.
What caused the outage?
Thus far there has been much finger-pointing by Nasdaq, chiefly in the direction of NYSE-Arca. The blame game is no surprise and there has been no official cause released just yet. In the meantime, what we do know is that gigantic bursts of quotes occurred just prior to the system breaking. These quote spam methods employed by HFT can be similar to DDoS attacks, as we’ve seen in the past.
— Eric Scott Hunsader (@nanexllc) August 23, 2013
The problem first surfaced at 10:58:41 – many stocks had crossed quotes (from a quote outage)
— Eric Scott Hunsader (@nanexllc) August 23, 2013
The charts below illustrate the disproportionate quoting that occurred. The thick red line represents the day of the outage, which officially began at 12:03 when the SIP went down.
What was the result?
Nasdaq decide to halt trading entirely on its system and in all “Tape C” securities, or those listed on the Nasdaq exchange. As they were unable to provide timely and accurate information to participants, it made sense to stop all trading so as to not officially provide an unfair advantage to any single participant. Because of this, it was literally impossible to trade Nasdaq listed stocks or their options for three hours on Thursday. Popular names like Apple, Amazon, and Microsoft were all halted. Quotes from industry participants obtained by the Wall Street Journal show the confusion during the time.
“It’s really shocking,” said Ramon Verastegui, head of global engineering and strategy at Société Générale, during the outage. “If we want to trade Apple, we can’t.”
“This takes confidence from the markets,” said William “Packy” Jones, chief executive of JonesTrading Group, which handles trading for hedge funds, mutual funds and other institutional investors. For much of the day, he said, traders were asking, in reference to published prices, “Are these prints real, or are they not real?”
As you can see, the Nasdaq Composite flat-lined.
The most curious aspect of the outage is that trading continued after the SIP was broken. So while the market was seemingly closed for most traders in a stock like Apple, it continued to trade among some participants as if nothing was wrong. Any firm not relying on the SIP for trade and quote data would have been unaffected by its malfunction.
Who doesn’t rely on the SIP?
High frequency trading firms do not. Via co-location and direct data feeds, HFT are plugged directly into the exchange computers allowing them to calculate the data on their own, essentially a synthetic SIP that is faster and more accurate. Nanex calls this discrepancy between direct feeds and the SIP downright illegal.
This is because exchanges are providing data to High Frequency Traders via direct feeds ahead of the SIP or consolidated feed. This is a clear violation of Reg NMS (what the SEC fined the NYSE $5 Million for). In fact, this behavior renders Reg NMS moot.
The same problem arose in Amazon’s stock, where the NBBO was seemingly dead, only this occurred at 11:01, about an hour before the entire SIP crashed. The trades continued unaffected, assumingly by the same directly connected HFT firms.
Was this an orchestrated event?
While rumors were abound instantly invoking fears of a hacking or possible terrorist cyber attack, the cause most likely resides on American soil inside a server farm. To illustrate the ability to profit in this scenario, considering the following description.
Let’s assume you were at a farmer’s market with various stands selling apples. In the middle of the market was a chalkboard (the SIP) displaying prices and quantities at which apples were just bought and sold, as well as bids and offers for future sales. What if one was able to, in the blink of an eye (or less actually), erase the chalkboard while simultaneously buying a majority of the available apples? One could turn around and sell their apples to other customers at their own price since others would have nothing to base a “fair” sale price upon. Or once the purchases were complete, one could allow the chalkboard to be re-written with new prices. Given the sudden drop in apple supply, the price would assumingly be higher, and that individual would be the new owner of an apple cart with a sudden appreciation in value.
It is not yet known whether any HFT firm attempted to break the SIP, but it is clear they would be capable of doing so and in a position to benefit from the subsequent darkness in pricing experienced by other market participants. Further, if any HFT is responsible, willfully or otherwise, Nasdaq is unlikely to blame them publicly. HFT is the biggest customer for a for-profit exchange, providing massive trading volumes and purchasing direct data feeds and co-location of their servers. Given this inherent conflict of interest, the argument against the current structure is valid.
It is now apparent to market data experts Nanex, that the gigantic surges of quote information did not come from an HFT algorithm. In fact, the massive traffic came from the Nasdaq itself. A glitch in its software caused 50 minutes worth of quotes to be sent through the SIP in only 3 seconds of time. This massive compression of data reeked havoc on the NBBO and appears to have led to the SIP shutdown. Below is an example from one stock. Note the pattern in quotes are the same, however, the pattern on the right played out much faster.
We’ll continue to monitor ongoing research and post any new updates or relevant information.