Saturday, May 26, 2012

Algo vs Algo and the Facebook IPO

Nanex research on algo vs algo activity during Facebook's IPO (via zerohedge).

Do we need to impose a small random delay on all transactions, or possibly a small transaction tax?

Did a Stuck Quote Prevent a Facebook Opening Day Pop?

On 18-May-2012, within seconds of theopening in Facebook, we noticed an exceptional occurrence: Nasdaq quotes had higher bid prices than ask prices. This is called a cross market and occurs frequently between two different exchanges, but practically never on the same exchange (the buyer just needs to match up with the seller, which is fundamentally what an exchange does).

When Nasdaq's ask price dropped below its bid price, the quote was marked non-firm -- indicating something is wrong with it, and for software to exclude it from any best bid/offer calculations. However, in several of the earlier occurrences the first non-firm crossed quote was immediately preceded by a regular or firm crossed quote!

During the immediate period of time when the Nasdaq quote went from normal to non-firm, you can see an immediate evaporation in quotes from other exchanges, often accompanied by a flurry of trades. We first noticed this behavior while making a a video we made of quotes during the opening period in Facebook trading.

The reaction to the crossed quote often resulted in the spread to widen from 1 cents to 70 cents or more in 1/10th of a second! It is important to realize that algorithms (algos) which are based on speed use existing prices (orders) from other exchanges as their primary (if not sole) input. So it is quite conceivable, if not highly likely that these unusual, and rare inverted quotes coming from Nasdaq influenced algorithms running on other exchanges.

It is now more than a curiosity that the market was unable to penetrate Nasdaq's crossed $42.99 bid which appeared within 30 second of the open and remained stuck until 13:50. Could this have prevented the often expected pop (increase) in an IPO's stock price for FaceBook?

This also brings another example of the dangers of placing a blind, mindless emphasis on speed above everything else. Algos reacting to prices created by other algos reacting to prices created by still other algos. Somewhere along the way, it has to start with a price based on economic reality. But the algos at the bottom of the intelligence chain can't waste precious milliseconds for that.They are built to simply react faster than the other guys algos. Why? Because the other guy figured out how to go faster! We don't need this in our markets. We need more intelligence. The economic and psychological costs stemming from Facebook not getting the traditional opening day pop are impossible to measure. That it may have been caused by algos reacting to a stuck quote from one exchange is not, sadly, surprising anymore.
Confused? See here :-)


Rodrigo Guzman said...

do you have a good intuition for what kinds of effects we'd see if we imposed the random delay?  naively it seems like a good idea, but this market thing is a bit non-linear :-)  could the lowered liquidity (i'm not even sure if that's what happens...) cause trouble in some complicated way?

David Coughlin said...

I'm surprised that they hft-strategy kids didn't blow up the NASDAQ with that crossed price.  I wonder what kind of order sizing algorithms they have hard-coded and what kind are functions of the market size.

Ken Condon said...

Kind of reminds me of the old (now dated) black and white but highly entertaining movie Pi. Although in this case the central character was a piece of hardware (computer chip) and not a software algo. Still-it was about attempting to outguess the markets and some nefarious characters involved.
Here is an old Ebert review of the pic if one may be interested.

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