We have spent the last two weeks dissecting the two major causes of the infamous 22% one-day drop in October 1987, and how those two causes are exponentially bigger factors in markets today.

Now, are you ready for the really bad news?

It’s about the liquidity myth, the story that says the market’s mechanical wheels are well greased.

It’s not just a myth… It’s a total lie.

Sure, there’s liquidity when markets go up, when it’s not needed. But when things go south – and they will – the myth will be revealed for what it is.

What most people believe about liquidity is a lie convened by conspiracy.

Here’s how the new portfolio insurance game and ETF arbitrage are going to unmask the frightening truth about market liquidity and seize the wheel of fortune…

Welcome to Your Nightmare

While regulators were sleeping on the job, Wall Street remade the two principal causes of 1987’s catastrophic one-day crash – remembered as Black Monday.

First, portfolio insurance, the external kind, the kind you buy to insure your portfolio won’t tank in a crash, the kind that became a hot Wall Street product in the 80’s, isn’t what the Street’s selling today.

What replaced it is something everyone’s supposed to feel more comfortable with: internal insurance.

Your portfolio’s self-insured if it automatically rebalances itself when bad stuff happens or, if you’re a passive investor, your internal insurance rider says to ride crashes out because stocks always go back up.

For big portfolio managers, the need for external insurance has been replaced by risk parity, volatility-targeting, and rules-based quantitative portfolio management game theory.

The problem is, the game they’re all playing is the same game based on volatility.

When volatility spikes and triggers wave after wave of sell orders, everyone’s going to find out they measure volatility the same way. They’re in the same positions, and they’re all rebalancing by selling the same things with spiking volatility into the same sinking market.

Second, passive investors, whose internal insurance is predicated on stocks always rising historically, who without knowing it count on index arbitrage to keep their ETFs from coming unglued, are going to find out that “historically” is time relevant, and that arbitrageurs will hammer their ETFs and stocks.

So, when panic strikes, the supposedly passive investing crowd will becomes active, and everyone’s going to find out that ETFs aren’t magic boxes; they’re stuffed with the same stocks everyone else’s ETFs are stuffed with, and the same stocks that everyone’s in.

And arbs are going to be frontrunning them down in waves.

The Frightening Unintended Consequences of Modernized Markets

A couple of decades ago, it used to be that selling, as bad as it could get, was more orderly on the way down, even if the way down was 12.5 cents, or 50 cents or a dollar or two at a time, time after time.

That’s not the case anymore.

Two things happened to change the way stocks trade:

1. In the mid-1990’s, ECNs (electronic trading networks) challenged the NYSE, the AMEX, and the Nasdaq. These new trading platforms paid traders to send, buy, and sell orders to them, instead of routing them to traditional exchanges. Traders and investors spread their orders around, reducing the number of shares to buy and sell at different price levels at every trading venue.
2. After April 2001, all listed stocks traded in the U.S. could trade in increments of one cent. Before that, stocks traded in minimum increments of 12.5 cents. Decimalization narrowed bid-ask spreads, but also made it harder for specialists and market-makers to make money. Narrower spreads increase the risk of taking one side or another as a liquidity provider.

The unintended consequences of these modernizing events are:

1. Orders to buy and sell are spread around to competing trading venues, reducing depth and liquidity at each of them.
2. Depth and liquidity are thin everywhere, so investors don’t leave big standing orders on anyone’s books anymore.
3. All specialists and market-makers at the exchanges and trading venues don’t see big order flow; they aren’t incentivized to trade for themselves and don’t provide liquidity like they used to.

Enter the HFT dragons.

It didn’t take long for a handful of big powerful trading firms and richly-backed startups to figure out how to intentionally game the unintended consequences of modernizing markets.

How HFT Works

With trading orders being directed to different exchanges, where they’d be matched internally or redirected to be executed, new high frequency trading (HFT) desks figured out if they could read all the orders being sent to all the different exchanges.

Before those order ever get there, HFTs would know if there were more buyers or sellers, and how much they wanted to buy and sell, and they could front-run them and make billions of dollars doing it.

HFT firms pay public and private exchanges to “see” all their incoming orders. They use superfast computers, locate their servers next to exchanges’ servers to enhance speed, run their own fiber-optic cables across the country as straight as possible to gain millionths of a second of speed advantages, and have their own towers for the same purposes. They do whatever they have to do to see incoming orders headed to exchanges so they can front run them.

By seeing what other traders and investors intend to do, HFT shops can tell how much of a stock someone is willing to buy at what price. They simply jump ahead by buying stock (or short-selling) what’s offered at the price someone in the “wire” is trying to get to. With that stock now in the hands of the HFT computers, when the legitimate buyer’s order gets to its destination, the stock the buyer wants is gone, and they must pay up to get it. ,

And who do you think is there to sell the stock to them a penny higher? When the buyer’s order is upped a penny and re-sent, the HFT computers see it coming, know where it’s going, and get there ahead of it with stock to sell.

That’s what HFT is all about. Only, it’s not illegal. They conspired with the exchanges and with the SEC to be able to read everyone’s orders.

High-frequency traders pay the exchanges for access to their servers. They co-locate their servers next to the NYSE’s servers in a giant server farm the NYSE got permission from the SEC to open in New Jersey to charge HFT shops top-dollar rent to co-locate next to the exchanges’ servers. Of course, the HFT players financed friendly legislators’ campaigns and paid millions to lobbyists to get legislators and regulators to bless what they wanted to do. And they got it.

What the market got was a completely false sense of liquidity.

On any given day, HFT trading accounts for between 30%-70% of trading volume. They aren’t market-makers providing liquidity. They’re “market-takers” facilitating trading for their own benefit.

It’s all fine on the way up, but on the way down everyone knows HFT shops turn off their computers. It’s a one-way market, and they don’t play in one-way markets. There’s no free arbitrage, or free front-running, as the case truly is.

The big market-makers are gone, the specialists are mostly gone. They’ve been replaced by rules-based trading algorithms.

So, when the next round of panic selling spikes volatility, triggering all those risk parity and volatility-targeting portfolio insurance schemes to sell, causing markets to fall farther, panicking passive investors and turning them into active selling, and unleashing arbs who will front ETF selling by shorting ETFs and their underlying stocks

Then, there won’t be any HFT liquidity providers, there won’t be any specialists or market-makers, and there won’t be any bids lower; there won’t be anything standing in order books waiting to catch falling stocks.

That’s when we’ll see – again, like we did in the flash crash and in August 2015 – that there is no liquidity.

HFT liquidity isn’t a myth – it’s a lie. The market doesn’t have any liquidity, and that will spell doom for any hope of stopping a crash before it happens.