The SEC-CFTC report on what caused the Flash Crash left a lot to be desired in the eyes of many market experts. But the report did succeed in exposing how the behavior of market participants on May 6 helped exacerbate the conditions which led to the historic plunge, according to Investment Technology Group's Managing Director Jamie Selway. In an interview with Advanced Trading, Selway explains how the Flash Crash boosted regulators' knowledge of how high frequency trading functions and why they don't need to step in to curb market fragmentation.
What vulnerabilities within the market did the Flash Crash expose?
Selway: The biggest one is that a lot of market participants are using data elements of various kinds to sense for risk. And so when they sense risk, they reduce their liquidity and kind of trade smaller and trade accordingly. I think there's a sense in which a lot of those went off on May 6 and they weren't uniform. So you had people going away from the market at different times, which led to a mismatch in liquidity because the sellers of futures, and then of stock, didn't get the message that risk reduction was happening on the liquidity provision side. They continued to consume liquidity and they got bad results. One thing that has become clear is that as the market senses more risk, the notion of slowing down jointly or stopping is not a bad one. And we have it elsewhere. We have it in the futures market today with limit up and limit down. We have it at the index level in the market today with the Dow-based broad market circuit breaker. We don't really have it at the single stock level and it seems like that's a lesson learned. We need some measure to let people know that it's time to stop trading and some uniformity around that process.
So the market needs signals of when to stop trading, or perhaps slow things down?
Selway: I think people look at CME and they say CME handled it successfully and what did CME do? They sold off pretty aggressively as liquidity was withdrawn, but then it hit a stop/spike functionality, essentially a 5 minute pause and liquidity came back in the market on the good side and the market rose after. There's a sense in which when things are sort getting a little bit out of wack, things look volatile, people don't know what's going on - people will tone down risk and eventually stop providing liquidity and in a situation like that. It's not a bad thing for the market to pause, re-establish itself while liquidity fills back in. So you ensure that price discovery is quality as opposed to random and dispersed.
Why were some market experts critical of the SEC-CFTC report, saying it didn't go far enough?
Selway: People think the SEC's had a lot of time; they've got a lot of data. They should come forth with both fact-finding - which is really what the report was - it was fact-finding, and I would say a dismissal of a couple working hypothesis around the notion that maybe LRPs or various other market structure elements like fragmentation or self-help, some of the market structure issues that some people theorize had become part of it. It found fact and batted those down but it didn't come forth with a brand new solution, so to speak. And from my perspective, that's actually to be celebrated. I think the notion is that they sort of didn't press things down to one bad guy and a tidy rule or two that could be used to make sure it would never happen again. The reality is the situation is much more complicated and there really isn't a policy change we could make that can fix what happened with May 6.
The other point to make too is this report is essentially a joint report to a committee formed by the CFTC-SEC jointly. If this would have been a regular lay of SEC work, I think this criticism would be fair, that the SEC had a lot of time and a lot of data to move beyond fact and towards proposals. But in fairness to them, it's a little bit bigger than them. It's a report to a committee; the CFTC is involved. The CFTC features most prominently around any kind of circuit breaker activity they extend to the futures markets and the SEC just can't do that. So I think the joint nature of the report, and frankly the magnitude of the event, both contributed to the sense that this isn't a regular way of policy making.