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Is the May 6 "flash crash" in U.S. stock markets the new normal?

By Edward Krudy

NEW YORK (Reuters) - The "flash crash" in U.S. stockmarkets that shook investors on May 6 may be the first of many as the market's herd mentality is exacerbated by ultra fast trading strategies that are rapidly spreading around the world and across asset classes, experts said on Thursday.

An explosion of new media such as blogging, micro blogging, and chat rooms is leading to a huge increase in the news flow that investors use to trade. That combined with the sheer speed at which thousands of transactions can move in one direction is set to increase volatility.

"When this becomes prolific there are opportunities for multiple May 6s to occur," Adam Honore, research director at Colorado-based research and advisory firm Aite, told an industry conference in New York.

The warning of a repeat of May 6, when the Dow Jones industrial average fell some 700 points in minutes before sharply rebounding, comes on the same day the U.S. Securities and Exchange Commission approved circuit breakers that halt large U.S. stocks which fall 10 percent in five minutes.

The regulators, who introduced the rules as a direct response to the May 6 crash, are trying to restore confidence to a market that has been traumatized during the financial crisis of the last two years.

Erratic intraday moves in stock prices have become more prevalent, with some investors complaining about fragmented markets and a lack of transparency.

Computer-driven high frequency trading accounts for about two thirds of transactions in U.S. equities, according to some estimates, and is rapidly spreading to options trading and foreign exchange as well as to markets as diverse as India and Canada.

The cause of the May 6 crash is still a mystery but high frequency trading strategies that execute trades in micro seconds are thought to have aggravated the speed of the fall. Although some see the SEC's moves as a necessary first step regulators are widely seen to be behind the innovation curve.

Honore believes part of the problem is that many high frequency traders are using similar strategies which has the effect of magnifying the herd mentality in markets. When the trading starts to move in certain direction other traders, not wanting to get caught out, start to follow.

Also, while markets in the past relied on news flow from a few big providers, the advent of micro blogging services like Twitter and electronic chat rooms have increased the tradable information available to investors. Honore believes that someone with a good understanding of how those networks work could manipulate prices.

Whether taking advantage of statistical aberrations between Brazilian depository receipts and their underlying equities of co-locating computers next to exchange servers in Mumbai, high frequency trading is spreading fast.

"We have not talked to a single person this year that does not have plans to move into another asset class, and frequently into another geography," said Honore

Some estimates say high frequency trading will account for as much as 80 percent of U.S. equity trading by 2012 and 30 percent to 35 percent in Canada by the end of this year.

The is also strong interest in peripheral markets. Ashish Pabalkar helped set up Quant Capital, a Mumbai-based high frequency trading shop, after his former employer Lehman Brothers went bankrupt in 2008. His company is typical of the type of niche operators springing up around the globe.

Quant Capital practices statistical arbitrage, or "stat arb" in the industry parlance, in the Indian equity and futures market. He estimates high frequency trading accounts for less than 5.0 percent of trading in India but sees that growing to 30 percent to 40 percent in 4 or 5 years.

(Reporting by Edward Krudy)

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