'Flash Crash' Prompts a Rethinking of the Rules
"The numbers are orders of magnitude from what we think would be realistic," says Ratterman. "We like the idea of a CAT, … but maybe it needs to be T+1 and not real-time. There are ways it can be done at a far lower cost to the industry."
Yet, in a world where the large broker-dealers spend $200 million to $250 million a year on data feeds, the price does not seem extraordinary, according to Sang Lee, managing partner at Boston-based Aite Group. "It's not a huge surprise that something that should be fairly easy to capture costs that much to maintain," Lee says. "I'm sure brokers are not happy about adding cost at this time, but it's better than not understanding what goes on in the market."
All Together Now?
Even as the SEC acted relatively rapidly in the wake of the Flash Crash and emerged with fairly sweeping regulatory changes, exchanges began taking their own remedial actions independent of regulators. Nasdaq OMX Group, for example, announced that it would implement in the third quarter its Volatility Guard program, which goes beyond the SEC's S&P 500 circuit breaker, and when necessary employ trading halts of varying durations across all listed securities.
There is an indication that these programs can be effective. At BATS, which represents about 10 percent of U.S. equity trading volume, market order collars (MOCs), in place since the exchange's founding, convert any inbound market order into a limit order constrained to a trading range of 5 percent of the prevailing price of a security. As a result of this policy, BATS executed only a fraction of its trades during the Flash Crash - about 2 million of the 49 million received during the height of the plunge - and canceled the rest, rather than breaking them retroactively, relates CEO Ratterman.
The implications of a broken trade versus a canceled trade are significant. A canceled trade means the two parties can go on as if the trade never happened. A broken trade means one side of the transaction is not fulfilled, which can be extremely problematic for short-term trades in the same securities, a hallmark of the high-frequency style and of market making in general.
"High-frequency strategies trade in small increments," explains Manoj Narang, founder and CEO of Red Bank, N.J.-based Tradeworx. "I could buy 1,000 shares and sell 1,000 shares all day long. If they break all my buys, I'd be short 100,000 in one fell swoop, which is much larger than any position I would have taken." That could put a firm such as Tradeworx in jeopardy of defaulting on its margin requirements with lenders, notes Narang, who adds that the possibility made the decision not to trade at all during the Flash Crash an easy one.
"We have a philosophical concern about the use of market orders in general," says BATS' Ratterman. "[On May 6] we had a dampening effect on prices that were going to go far out on our market and did not execute outside a reasonable range." BATS also does not automatically replenish stub quotes, as other exchanges do, so the likelihood of a trade repeatedly executing against a clearly erroneous quote is diminished, Ratterman contends.
Despite the validation of his company's philosophies during the recent crisis, Ratterman says, he still believes that "In times of stress, all the markets ought to behave the same way." He adds, "It is not the time for markets to differentiate ourselves based on how we handle runaway, stressful situations. I would like to see additional work done to make the [circuit-breaker] regulation even better." Ratterman advocates that the equities market adopt the "limit-up, limit-down" mode of the futures market, which, rather than halt trading in a security, ceases executions past predetermined trigger points.
While free-market innovation should prevail and exchanges should differentiate themselves in their operating models, agrees Matt Samelson, analyst at Woodbine Associates in Stamford, Conn., now is the time for regulators to act more definitively and impose clearer, simpler, more uniform rules of conduct when extreme events occur, he says. "When we are talking about curtailing events like this, it is very important to have consistency across market centers," Samelson says.
Simple Is as Simple Does
Fortunately, regulators are recognizing that the lack of such consistency and the uneven application of regulation drives market complexity to the point where few people understand it, suggests Aite's Lee. Spurred by the collapse of the credit market and now the Flash Crash, the meetings that have taken place between the CFTC and the SEC this year are significant, as the two organizations, which regulate many of the same firms in different markets, rarely meet and are controlled by different interests in Congress, he adds. While the two regulators have resisted merging, as has reportedly been suggested by Treasury Secretary Timothy Geithner, they have pledged to work together more closely.
"Lacking an overall market-level mechanism, it all fell apart," Lee says. "The argument for market competition did not hold up here. It really showed the disadvantage of fragmentation. Competition leads to better prices and innovation - but what we might have overlooked is that there is no level of uniformity."
The May 6 event has provided another forum for an open referendum on the nature and purpose of financial regulation. But as much as a lack of regulation has been blamed for the global markets' woes, some experienced traders say the spaghetti-like nature of today's financial markets is due to overly complex regulation, not unfettered free-market enterprise.
"Any time you have a game with rules, some people will be better than others - that does not make the game unfair," says Tradeworx's Narang. "Trying to make the game more complicated does not make it more fair. That always backfires."
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