Flash crash root caused by the Internalizers who became the real villains
Here is what the internalizers do. This is especially when it came to the Flash Crash earlier this year:
Typically, the internalizer then takes the other side of the trade for “a very large percentage” of this flow. On May 6th, the SEC found that there was a departure from this practice (see page 58 of the SEC Report). As the market was falling dramatically, the internalizers (we don’t know which internalization firms the SEC is referring to) continued to short stock to retail market buy orders, but they dramatically stopped internalizing retail market sell orders, and instead flooded the public market with those orders. When the market stopped falling, and rose dramatically almost as quickly as it fell, the internalizers reversed that pattern, and internalized retail sell market orders, and flooded the public market with retail market buy orders. To restate this plainly, the internalizers used their speed advantages to pick and choose for its P/L which orders it wanted to take the other side of. For the ones they did not wish to take the other side of, they routed them to the markets as riskless-principal trades. The practice not only strikes us as patently unfair, but the number of orders that flooded the marketplace was massive. As such it caused data integrity issues (widening the difference between s
This is was what the SEC summarized:
“Many internalizers of retail order flow stopped executing as principal for their customers that afternoon, and instead sent orders to the exchanges, putting further pressure on the liquidity that remained in those venues. Many trades that originated from retail customers as stop-loss orders or market orders were converted to limit orders by internalizers prior to routing to the exchanges for execution. If that limit order could not be filled because the market continued to fall, then the internalizer set a new lower limit price and resubmitted the order, following the price down and eventually reaching unrealistically-low bids. Since internalizers were trading as riskless principal, many of these orders were marked as short even though the ultimate retail seller was not necessarily short. This partly helps explain the data in Table 7 of the Preliminary Report in which we had found that 70-90% of all trades executed at less than five cents were marked short.”
“Furthermore, in total, data show that internalizers were the sellers for almost half of all broken trade share volume. Given that internalizers generally process and route retail trading interest, this suggests that at least half of all broken trade share volume was due to retail customer sell orders.”
Even more disturbing was this: “Detailed analysis of trade and order data revealed that one large internalizer (as a seller) and one large market maker (as a buyer) were party to over 50% of the share volume of broken trades, and for more than half of this volume they were counterparties to each other (i.e., 25% of the broken trade share volume was between this particular seller and buyer.”
Find out more about flash crash details.
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