One Year After Flash Crash Regulators Vexed by Fragmentation
One year ago, regulators were unable to arrest a market collapse that erased $862 billion from stock values in less than 20 minutes. Yesterday, they agreed that their work to prevent a recurrence has yet to be completed.
Exchanges established circuit breakers to curb price swings across about 50 equity venues, adopted uniform rules on when to cancel transactions and eliminated quotes that let companies such as Accenture Plc (ACN) fall as low as a penny from about $41 on May 6, 2010. David Shillman, associate director of the Securities and Exchange Commission’s division of trading and markets, said yesterday that while the initiatives have worked so far, more needs to be done.
“It’s an ongoing task by the commission to make sure the regulatory structure keeps up with markets,” Shillman said at a Georgetown University conference in Washington. “We need to coordinate with the futures market. We don’t want a world where single-stock circuit breakers are going off at lower thresholds yet the index continues to trade.”
Twelve months after a mutual fund’s hedging strategy set off a chain reaction that sent the Dow Jones Industrial Average to its biggest slide since 1987, the SEC has acted to solve issues created by market fragmentation on equity exchanges. That the selloff originated on a futures venue run by CME Group Inc. (CME) in Chicago, overseen by the Commodity Futures Trading Commission, shows why even more coordination may be one of the SEC’s biggest challenges.
Almost 1.3 billion shares traded on U.S. markets in a 10- minute span starting at 2:40 p.m. New York time on May 6, 2010, six times the average, sending prices lower from New York to New Jersey and Chicago. The Dow Jones Industrial Average slumped almost 1,000 points intraday before paring losses.
While automated trading was blamed for feeding the rout, regulators have little choice but to rely on computers to prevent another one, said Frank Hatheway, chief economist and senior vice president at Nasdaq OMX Group Inc. (NDAQ) in New York.
Before electronic trading, “when there was a problem, the system would kick off and trading would be handled by a human,” Hatheway said. “Now we’re putting systems in place to do what people used to do in terms of handling the unexpected. There’s no other option.”
More than 19.3 billion shares changed hands in U.S. markets on May 6, compared with the daily average of 7.57 billion since then. While NYSE Euronext (NYX)’s three venues including the New York Stock Exchange give it the most business, electronic markets that didn’t exist before the mid-2000s, such as Bats Global Markets in Kansas City, Missouri, and Jersey City, New Jersey- based Direct Edge Holdings LLC, handle about 20 percent.
A study by the SEC and CFTC on Oct. 1 concluded that an automated sale of stock index futures without regard to price and computer-driven trading strategies helped trigger the crash, turning an orderly selloff into a plunge as buy orders vanished. Disparate rules across exchanges and delays in the dissemination of trading data, especially for stocks listed on the New York Stock Exchange, sowed confusion, regulators said.
The crash highlighted the loss of dominance for the 219- year-old New York Stock Exchange and Nasdaq Stock Market, founded in 1971. Volume in securities they list has dropped from as much as 80 percent in the last decade to less than 30 percent now. Orders are dispersed to as many as 50 competing venues, almost all of them operated by computers that match orders electronically. Twenty years ago, fewer than 10 exchanges competed for equity trades.
The exchanges and the Financial Industry Regulatory Authority, which oversees more than 4,500 brokers, worked with the SEC to introduce circuit breakers that halt trading in Standard & Poor’s 500 Index and Russell 1000 Index (RIY) stocks along with more than 300 exchange-traded funds when prices rise or fall 10 percent in five minutes. The markets last month proposed moving to a so-called limit-up/limit-down mechanism that prevents trades outside a moving price band.
“Exchanges and regulators have done a lot over the last year. Stocks can’t move as far out of whack as they could before,” said James Angel, professor at Georgetown University in Washington, “Murphy’s law hasn’t been repealed. Anything that can go wrong will go wrong. We need safeguards for when the next event occurs.”
Randy Snook, New York-based executive vice president at the Securities Industry and Financial Markets Association in Washington, said the circuit breakers and plans to move to a limit-up/limit-down system are an “important, necessary step to ensure we don’t have, on a stock-by-stock basis, extremes in volatility.” Consistency across exchanges and trading platforms are key to damping price anomalies, he said.
Competition among exchanges and alternative venues has reduced costs for investors and benefited professional traders by giving them more choices on where and how to do business, said Sang Lee, managing partner at Boston-based Aite Group LLC.
“Each venue, broker, high-frequency trader, market maker and asset manager reacted in a way that was totally rational for them,” Lee said. “Collectively it was a complete disaster, because there was no coordination across market participants.”
While firms will always respond according to their own mandates, “you need a certain level of minimal harmonization for how you’ll react as an industry,” he said. “If stocks go down in value by 90 percent, something has gone wrong.”
Blame for May 6 initially settled on a program for slowing trading on the NYSE known as liquidity replenishment points, which convert electronic trading in a stock into an auction overseen by a specialist.
The safeguards don’t extend to trading by other venues, which continued to execute buy and sell requests at whatever prices were available after depleting their existing orders. Many of those traded against stub quotes, or placeholder buy and sell requests at prices as low as a penny used by market makers to meet obligations to provide bids and offers.
Regulators found that the Big Board’s trading curbs didn’t cause orders to flow to other markets or high-frequency traders to shut down. The triggering of about 100,000 LRPs at the height of the rout, most for no more than a few seconds, along with data delays fueled confusion among automated trading firms and brokers, the SEC-CFTC report said.
Inconsistent policies for pausing trading across venues “were a problem but no one confronted it,” said Matthew Andresen, former co-chief executive officer of Chicago-based Citadel LLC’s market-making business. “They can be fixed. Compared to the 1987 crash, which lasted a day and a half, this took 18 minutes.”
Andresen, who ran the Island ECN that helped pioneer electronic equity trading, said “mini flash crashes” have happened every day over for two decades as stocks trading at the wrong price had to be canceled or adjusted. More people are paying attention to them now after the events of May 6, he said.
“When they affect everyone it’s a problem, but asking competitors to homogenize rules with each other is impossible,” said Andresen, who’s now co-chief executive officer at Headlands Technologies Inc., a quantitative trading firm in Chicago and San Francisco. “You need government to mandate it. Unfortunately it took a calamity to get that addressed.”
Trading curbs on individual stocks and ETFs should be coordinated with related stock index futures, Senator Carl Levin, a Michigan Democrat and chairman of the Senate’s Permanent Subcommittee on Investigations, said last month.
The SEC and CFTC plan to revamp the market-wide circuit breakers introduced after the 1987 stock crash that halt all trading across securities and futures markets when the Dow drops 10 percent before 2:30 p.m. The agencies are considering whether to use another index instead of the average, decrease the price- decline thresholds that trigger the curbs, and cut the length of the halt.
“When we pick a number for the market-wide circuit breaker, there’s keen interest in making sure it works well with whatever number is picked for limit-up/limit-down,” Shillman said about the trigger thresholds. The SEC hopes to implement constraints for individual securities by the end of the year, he said.
The Dow fell as much as 9.2 percent on May 6, its biggest tumble since the crash of 1987, before closing down 3.2 percent. Share prices for companies such as Accenture and Exelon Corp. fell to pennies before rebounding minutes later.
Stock exchanges agreed to cancel trades on May 6 that were 60 percent or more away from their price at 2:40 p.m., when the selloff intensified. Transactions in 326 securities, 70 percent of which were ETFs, were broken that day, regulators said last year. About 20,800 separate trades were voided, including many when orders hit stub quotes.
Exchanges, Finra and the SEC banned stub quotes starting in December, requiring market makers to supply orders within 8 percent of the national best bid or offer. The goal was to provide protection against a surge of orders that might otherwise overwhelm markets, according to Schapiro.
Uniform rules for trades deemed “clearly erroneous” were also written to give investors more certainty about when and at what levels executions would be voided. Knowing when transactions will be canceled allows traders to avoid losses or rule infractions such as holding improper short positions when stock purchases are canceled while the subsequent sale of the shares at a higher price is left standing.
“Regulators often get a bum rap,” Andresen said. “They presided over the modernization of markets over the last 15 years, starting when spreads were artificially wide because prices didn’t have to be honored. They moved in fits and starts, but in a fairly methodical way to get us to a place where we have the most efficient, liquid market in the world,” he said. Failing to coordinate rules “was a colossal oversight, yes, but a more sober and complete analysis shows many successes mixed into that history.”
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