Look to high frequency trading, EFTs in Shanghai's flash crash, not retail investors

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Picture this: the market plunged 9 percent in around 30 minutes of hectic trading. Regulators raced to contain the damage, that was estimated in the trillions. Later, the plunge was repeated with a market collapse of 6.5 percent as 1,100 points were wiped in about five minutes. Trading was halted multiple times and circuit breakers were praised for preventing a full-on market crash of epic proportions.

It just goes to show that this is an untrustworthy, poorly developed market that has to be managed externally by imposing trading halts.

Hang on, there's just one problem with this assumption. The 9 percent plunge happened on May 6, 2010. It was the infamous Flash Crash on the New York Stock Exchange. The second 6.5 percent fall was the August 24, 2015 flash crash, also on the NYSE.

And rather than signaling the end of the financial world as we know it, markets simply shrugged their collective shoulders and moved on.

But analysts seem to apply a different yardstick to the China market and are using this week's flash crash to highlight what they see as China's economic disaster.

This is more than easily dismissed as double-standard analysis, because closer examination suggests some alternative explanations.

Let's first go back to the US flash crashes. The 2010 crash was widely attributed to the activity of exchange traded funds (ETFs). The 2015 crash was attributed to high frequency trading because sell algorithms cascaded in a falling market.

The true reasons are certainly more complex, but it's the nature of these suspects that is interesting because they highlight the connection between the derivative markets and the underlying market.

The Shanghai Composite.
Daryl Guppy | guppytraders.com

One of the key connections is the rapid placement and withdrawal of trading orders that lies at the core of high frequency trading. These are placed in the futures and associated markets. In its subsequent investigation, the Commodity and Futures Trading Commission (CFTC) concluded that this activity was at least significantly responsible for order imbalances in the derivatives market, which in turn affected the stock market.

The key feature is that these types of extreme and rapid market collapses are most often associated with markets dominated by derivative trading. These crashes are caused by institutional trading from ETFs and HFT. They are not caused by mums and dads trading because mums and dads simply do not act in such a coordinated fashion in such a short timeframe. Mums and dads also do not have the leverage to shift markets in this way within 30 minutes or an hour. That power lies in the hands of large-scale derivative traders.

So, heres the rub. The onshore China market is dominated by retail traders. The offshore derivative market is dominated by institutional funds and ETFs and trading activity has been facilitated by the Shanghai-Hong Kong Stock Connect that opened in November 2014.

Chinese authorities have been concerned for some time by allegations of Qualified Foreign Institutional Invetor (QFFI) funds being used in offshore shadow derivative trading. In June 2015 there were claims that the Shanghai index sell-off from the high of 5,176 was preceded by a spike in the placement and rapid removal of sell orders that is typical of HFT activity. It took the CFTC 4 years to deliver a final report on the 2010 Flash Crash so its unreasonable to expect a CSRC report on the June 2015 fall anytime soon.

The January 1 Shanghai flash crash has all the characteristics of the NYSE flash crashes but in a market that is not dominated by fund managers and institutional trading. It's the imposition of circuit breaker-thinking, imported directly from the flash crash-vulnerable NYSE market, that stopped this Shanghai flash crash from worsening.

It's convenient but far too simplistic to blame Chinese retail traders. The pattern of order placement in the physical and derivative markets need further investigation.

Daryl Guppy is a trader and author of Trend Trading, The 36 Strategies of the Chinese for Financial Traders, available from www.guppytraders.com.. He is a regular guest on CNBC's Squawk Box and a speaker at trading conferences in China, Asia, Australia and Europe.

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