Raptors at the Liquidity Fence, and the Big Whoosh

The fences are electrified, right?
That's right.  But they never attack the same place
twice.  They were testing the fences for weaknesses.
Systematically.  They remembered.
                     -- Jurassic Park (1993)

There are strange whooshy feelings in capital markets these days. I wrote last week about the run on the shadow liquidity system which, in part, led to the Big Whoosh: Thursday’s "flash crash". Except the run hasn’t really stopped.

What is going on? It’s a testing process. Markets — and traders — are trying to figure out where the liquidity weaknesses are: How far down, in what stocks, and at what times, do things have to be bent/folded/spindled before they bust again? Where are the real liquidity replenishment and cut-over points? At what point will liquidity again disappear, in what stocks?

The market is, like raptors in Jurassic Park, testing the fences. It has discovered a major set of coupled, equity-related weaknesses in the shadow liquidity system, in the absence of a central market limit order book, in the best price national market system, in exchange-traded fund arbitrage, and in off-exchange trading networks. It will try to exploit those weaknesses again, which is the other side of why I hear non-stop from opportunistic sorts who have already positioned themselves accordingly in distant put/call land on the SP500.

Rather than thinking of the "flash crash" as an outlier event, think of it as a feasibility test. There are inflection points in the trading curve — time, price, and action — where the system breaks down, and they are systemic problems not easily resolved by new rules. In the interim, raptors will, like today, continue pinging the fences, systematically, looking for that same weakness.