Another Suspect in the Flash Crash: 'Quote Stuffing'

It's now nearly four months since the May 6 flash crash, when the Dow lost nearly 1,000 points in 20 minutes before rebounding somewhat, but the Securities and Exchange Commission still doesn't know why it happened. However, one theory it's investigating is so-called quote stuffing.

To find out more about quote stuffing, I called on Sal Arnuk of trading firm Themis because he had earlier helped me understand a related trading techniquecalled latency arbitrage, which I wrote about this June. In fact, the way Arnuk describes it, quote stuffing is just another way to make a few pennies by taking advantage of small price differences between the exchange where a trader buys and the one where he sells.

Arnuk explained quote stuffing as a form of latency arbitrage in which a trader places a huge volume of orders on the New York Stock Exchange that gets canceled a split second later. For example, the trader might place an order to buy 20,000 shares a second at $30 a share for a stock that normally trades at $60 a share. If the NYSE can move only 10,000 orders in a second, a 20,000-share order will slow down the exchange because the quote stuffing tricks the NYSE into thinking that the 20,000-share order is valid. Although the trick time is very short, it's long enough to slow down trading.

A Risk-Free Way to Profit

Quote stuffing is latency arbitrage on demand, according to Arnuk, because the trader can control when the delay occurs. The split second before the NYSE gets that huge order is the time to buy on the delay that the trader knows will occur when that order hits the exchange.

As a refresher, latency arbitrage is a risk-free way for a select group of well-heeled traders to skim money out of the market by taking advantage of tiny timing differences among different exchanges. A real-time National Best Bid and Offer (NBBO) market operates a split second ahead of delayed markets like the NYSE.

As Arnuk explained to me in June, with latency arbitrage, traders can buy a stock on an NBBO exchange at, say, $30.10 and then sell that same stock a split second later for $30.12 on the NYSE -- making a quick two cents a share profit with no risk. The nice thing about quote stuffing from the trader's perspective is that they can make latency arbitrage profits whenever they want. But here's the kicker: The NYSE gets substantial fees from these traders so they can locate their computers right next to the NYSE computers to take advantage of these timing differences.

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While some people think securities markets should be fair to all participants, latency arbitrage makes the markets risk-free for those participants who pay up for these "co-location" computer setups. And that makes the markets quite unstable for everyone who doesn't play that game, like the average investor.

For additional insight, Arnuk referred me to Eric Hunsader of Nanex.net, which takes real-time snapshots of trading in specific securities. Nanex is a source for the SEC for the notion that quote stuffing may have caused the flash crash.

Nanex's analysis suggests that the flash crash happened because the quote stuffing contributed to such a big delay that many market participants concluded that the quotes were flawed. Therefore they stopped trading -- the absence of expected buy orders contributed to the market plummet.

If the market loses 1,000 points as a result of quote stuffing gone awry, why would these traders care? Just as $500 million in annual lobbying and campaign contributions from Wall Street gives us the best government money can buy, so do latency arbitrage and quote stuffing give us the fairest markets money can buy.