Market Fragmentation in U.S. May Get Regulatory Review
Federal regulators reviewing yesterday’s stock plunge will try to determine if the fivefold increase in the number of American equity exchanges has left them unable to manage the biggest surges in volume.
The selloff erased $700 billion from U.S. markets in eight minutes after actions by the New York Stock Exchange to slow trading increased volatility on other platforms, said Joe Ratterman, chief executive officer of the five-year-old alternative exchange Bats Global Markets Inc. NYSE Euronext Chief Operating Officer Larry Leibowitz said the Big Board prevented a bigger decline.
“There are times when differences in behavior are not good for the market or the investors,” said Ratterman, who recommends trading be halted across networks when investors are panicking. “This Thursday may have been one of those times.”
Financial Industry Regulatory Authority, the industry’s watchdog, said today that brokers must ensure they aren’t overwhelming markets with orders on as many as 50 U.S. equity venues when prices are falling. The Securities and Exchange Commission is seeking to determine if market participants accidentally or maliciously derailed trading, according to two people familiar with the situation. Lawmakers plan to hold hearings next week.
Almost 1.3 billion shares traded on U.S. markets in a 10- minute span starting at 2:40 p.m., six times the average, sending prices lower on platforms from New York to Kansas City. Nasdaq OMX Group Inc. said it canceled transactions in almost 300 stocks where swings grew too wide. Federal agencies began inquiries after the Dow Jones Industrial Average slumped almost 1,000 points intraday before paring losses.
While the first half of the plunge probably reflected normal trading as concern increased that Greece’s credit crisis would spread, the selloff snowballed because of orders sent to venues with no investors willing to match them, Leibowitz said in a Bloomberg Television interview.
Accenture Plc, Exelon Corp. and Philip Morris International Inc. were among U.S. stocks that dropped more than 90 percent as U.S. equities tumbled, before recovering within minutes, according to Bloomberg data. Prices fell to pennies in some companies after the NYSE switched from electronic matching to auctions, encouraging some sell orders to flow to smaller exchanges that had few if any buyers, according to Leibowitz.
“If you look at the charts you can see fairly clearly where the trades came in,” he said from New York. “It’s that V-shaped drop where it came down and snapped right back up. You had some very high-cap stocks trading down 50 percent or large percentages in a split-instant because there really was no liquidity in electronic markets.”
More than 29.4 billion shares changed hands in U.S. markets yesterday, the most since October 2008. In addition to traditional exchanges such as the NYSE, rivals Bats in Kansas City and Jersey City, New Jersey-based Direct Edge Holdings LLC handled millions of trades. About 2.6 billion shares traded on the NYSE, the lowest level relative to overall volume in three years, data compiled by Bloomberg show.
Rapid-fire orders trigger what the NYSE calls liquidity replenishment points, or LRPs, shifting trading into auctions overseen by market makers. While the system is designed to restore efficient trading on the Big Board, selling is so fast during times of panic that orders routed past the exchange may swamp other venues and exhaust buyers, said James Angel, a finance professor at Georgetown University in Washington.
That’s when prices may plummet as orders execute against so-called stub quotes. Brokers can set those as low as a penny a share because they’re never expected to be used. “In a situation where only one market stops trading, not only does it not help, it likely exacerbates the situation,” said William O’Brien, CEO of Direct Edge, which was founded in 2005. “Yesterday is a day that no exchange should be proud of.”
Increasing automation and competition have reduced the NYSE and Nasdaq’s volume in securities they list from as much as 80 percent in the last decade. Now, less than 30 percent of trading in their companies takes place on their networks as orders are dispersed to as many as 50 competing venues, almost all of them fully electronic. Twenty years ago, fewer than 10 exchanges competed for all U.S. equity trades.
The replenishment points are triggered regularly on the NYSE and promote efficient trading, according to Ray Pellecchia, a New York-based spokesman.
“Today you’re hearing about it because of the magnitude of the fall,” Pellecchia said. “Usually it’s not a market-wide move, it’s just a small group of stocks.”
Stocks slid for a fourth day today, erasing 2010 gains for U.S. benchmark gauges. The Standard & Poor’s 500 Index fell as much as 3 percent before paring losses to 1.5 percent.
Nasdaq OMX said it will cancel trades from yesterday that were more than 60 percent above or below price levels at 2:40 p.m. New York time, just before U.S. equities plummeted. The firm said it investigated trades between 2:40 p.m. and 3 p.m.
CBOE Stock Exchange canceled 18 trades of 100 shares that took place at 1 cent in Accenture over seven seconds starting at 2:47 p.m. The trades occurred against stub quotes, according to David Harris, the exchange’s president. Trades were canceled on CBSX because the market is newer and its book of orders is “thinner,” which led to transactions occurring away from reasonable prices, he said.
“We are all connected to each other,” Harris said. “We receive orders electronically and if an order requires an execution we execute it. If it’s away from the market and violates our clearly erroneous trade policy, we bust the trade.”
The market rout triggered scrutiny from lawmakers. U.S. Representative Paul Kanjorski, a Pennsylvania Democrat, set a May 11 hearing. U.S. Senator Ted Kaufman, a Delaware Democrat, questioned whether markets that increasingly rely on computer algorithms to execute thousands of transactions in seconds triggered false trades.
“This is unacceptable,” Kanjorski, who leads the House Financial Services subcommittee that oversees the SEC, said in a statement. “We cannot allow a technological error to spook the markets and cause panic.”
Nasdaq’s cancellation threshold of 60 percent meant that trades in Cincinnati-based Procter & Gamble Co., which fell as much as 37 percent for the biggest intraday drop in the Dow industrials, would stand. The world’s largest consumer products company said stock trades that pushed its shares down were probably an error. While NYSE has only a quarter of trading in its listed stocks, that’s enough to affect prices, O’Brien said. Moving to the slower auction process effectively means that only three quarters of the market is open.
“When a truly disorderly and unnatural trading is occurring, we should call a timeout, allow everyone to assess the situation and reopen the stock on a coordinated basis,” O’Brien said.
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