The so-called "Flash Crash" has prompted a great deal of head scratching, soul searching and finger pointing on Wall Street. A cascading series of events caused the Dow Jones Industrial Average to plunge nearly 1,000 points, with most of the free fall occurring in just 20 minutes.
Legitimate concerns about the global economy - rooted in the Greek debt crisis, the Gulf oil spill and concerns about sweeping regulatory changes planned for the financial industry - already were causing skittish investor behavior. But around 2:30 p.m. ET on May 6, the market's decline accelerated precipitously, and investors began selling at a loss, putting pressure on liquidity and driving some typically stable, bellwether stocks into the pennies. Just as quickly, the market recovered, leaving virtually everyone shaking their heads.
The industry and its regulators are still attempting to sort out exactly what happened, a pursuit that requires unprecedented cooperation among regulators of both the equities and derivatives markets and competing exchanges in both markets. Through this exercise, however, a dawning realization is emerging: The U.S. securities and derivatives markets are deeply interdependent, and the harmonization and simplification of rules across markets, exchanges and the regulators responsible for maintaining orderly markets is long overdue. Further, exchanges with disparate risk controls make little sense in a market that is instantaneous and interlinked.
Cracks in the Market Structure
Early blame for the Flash Crash was assigned to electronic trading in general, and specifically to its propensity to propagate trader errors quickly and seemingly uncontrollably across markets before any human can process what is happening. But a preliminary report issued May 18 by a joint committee of the Securities and Exchange Commission and the Commodity Futures Trading Commission (CFTC) determined that there was no evidence of trader error.
The Blame Game continued, with fingers pointing at nearly every conceivable party, from high-frequency traders to runaway algorithms. Now, however, the focus seems to be moving away from pinpointing individual traders, technologies or exchanges, and toward a sobering evaluation of the market structure's flaws.
Acting quickly to impose some sanity on the debate, the SEC and CFTC conducted an analysis of 19 billion trades, and the joint report issued May 18 focused on several major issues:
The New York Stock Exchange's Liquidity Refreshment Points (LRPs). When liquidity is not available, the NYSE's LRPs put the market into a "go slow" mode by briefly switching electronic trading in a given security to the live auction market. Automatic executions return after a trade is executed manually. On May 6, this had the effect of protecting trades that made it to the NYSE before the LRPs were called into action, but the fact that the LRPs are unique to the NYSE meant that orders had to go to less-liquid locations for execution, causing more havoc.
Self-Help Remedy. The NYSE's LRP program has been singled out largely because of its interaction with the so-called "self-help remedy." NYSE is the only exchange that has a go-slow mode. But because other exchanges are obligated by Regulation NMS to route transactions to the location of the National Best Bid or Offer (NBBO), the other exchanges are entitled to "declare self-help" and bypass the NYSE if it fails to respond in one second. In a panic-sell situation such as the one that occurred on May 6, orders were routed around the NYSE and were unable to access its substantial liquidity, thus driving prices even lower.
Stop-Loss Market Orders. Many electronic orders have automated stop-loss triggers, which turn into market sell orders when prices decline past a certain point. In a fast-moving, heavy-volume downward selling trend, the number of sell orders can quickly exceed the available buy orders and further drive down both prices and liquidity.
Short Sales and Stub Quotes. The SEC-CFTC report concluded that the majority of broken trades on May 6 - 70 percent in the five minutes between 2:45 p.m. and 2:50 p.m. and 90 percent between 2:50 p.m. and 2:55 p.m. - were short sales against stub quotes. Short sales - the practice of selling borrowed securities with the intent of buying the same securities back later to return to the lender - bottomed out when executed against stub quotes, which often are unrealistically low quotes maintained by market makers in order to meet their obligation to provide two-sided markets.
Exchange Traded Funds (ETFs). ETFs, which bundle multiple securities into a fund and track broad indices (such as the S&P 500), were particularly affected during the Flash Crash, representing 70 percent of canceled trades. NYSE Arca is the primary listing facility for almost all ETFs, which caused significant problems when the LRP triggered slow trading and the Arca pool became inaccessible for a time.
The Price of Orderly Markets
As a partial response to these conclusions, the SEC rolled out on June 14 a new cross-market "circuit breaker," which instigates a five-minute halt in trading if any of the stocks in the S&P 500 move more than 10 percent from any price in the preceding five minutes. But early reports indicate that this policy may need adjusting. For one thing, the circuit breaker does not cover ETFs, which many see as a flaw, considering the role ETFs may have had in the Flash Crash. Still, the new circuit breaker generally is regarded as an improvement.
The other major regulatory action to emerge thus far is a proposed Consolidated Audit Trail (CAT). Currently, there is no single database of comprehensive and readily accessible order and execution data, and the standards for data collection vary across markets. The SEC proposes to build such a database, accompanied by standardized rules for data collection.
The initial price tag estimate for the CAT was an eyebrow-raising $4 billion one-time investment, with an ongoing annual cost of approximately $2.1 billion. The start-up cost would be borne by exchanges and the Financial Industry Regulatory Authority (FINRA), to the tune of $351 million; by broker-dealers that would need to make changes to their own systems, at a cost of $3.7 billion; and by broker-dealers that use a third party to conduct their clearing ($287 million).
But is this a reasonable price to pay for accountability and orderly markets? Joe Ratterman, CEO of the Lenexa-Kan.-based BATS Exchange, calls the figure "preposterous."