Thursday, May 5, 2011
FT.com / FT Trading Room - Fears linger of new ‘flash crash’
Fears linger of new ‘flash crash’
By Michael Mackenzie and Telis Demos
Published: May 5 2011 18:23 | Last updated: May 5 2011 18:23
In the space of just 20 minutes a year ago on Friday, Wall Street tumbled hundreds of points, dumbfounding dealers, only to rebound sharply. The extraordinary gyration in stocks, dubbed the “flash crash”, stunned investors and revealed gaping holes in the equity market’s structure.
Such a chronic breakdown in the operation of the world’s largest stock market sparked an investigation by regulators, scrutiny from Washington and a flurry of new rules.
Yet one year later, unease lingers that in spite of new safeguards, stock prices are vulnerable to bouts of sudden selling. For all the talk and action, the big concern remains that the Dow could suffer a repeat of last May’s crash.
“We will have another flash crash, yes without question,” says James Angel, associate professor of finance at Georgetown university. “The combination of human nature, markets and technology means that at some point, something will misfire.”
After the flash crash, the Securities and Exchange Commission moved quickly to introduce circuit-breakers, designed to impose a “time-out” whenever trading in a stock causes prices to swing too wildly. It also plans to introduce a “limit-up, limit-down” mechanism to prevent trades outside a certain price band.
EDITOR’S CHOICE
Blown away by flash crash report - Feb-19
Tom Joyce, chief executive of Knight Capital, says: “The SEC responded in a measured and appropriate way and the introduction of circuit-breakers and soon-to-be-established limit-up, limit-down rules help reduce systemic risk.”
Other SEC changes include the elimination of “stub” quotes – quotes that are deliberately set at a huge variance to share prices by market makers to satisfy their obligation to maintain a two-sided market both for buyers and sellers of a stock.
Still to come are a possible recalibration of market-wide circuit-breakers that were not triggered on May 6 and a real-time “audit trail” to detect disruption.
The confusion surrounding the crash was, some believe, exacerbated by exchanges’ different rules. The New York Stock Exchange, for example, now uses its own circuit breakers, while Nasdaq has its own proposed version. They could drop their their independent efforts once market-wide mechanisms are fixed.
However, such steps, while they have been welcomed, are not intended to address more fundamental issues, including some that were raised by the SEC before the crash. Rather, they are designed, says John McCarthy, general counsel at market maker Getco, “to prevent the exact same May 6 from happening again”.
The plunge in stocks was compounded by some buyers briefly withdrawing their support and turning off computer systems, even though the largest groups, including Getco, remained in the market. Participants such as brokers that match trades internally or in “dark pools”, where orders are matched with prices not revealed beforehand, tried to sell millions of shares in the public market.
This led to thousands of trades being broken, with blue-chip stocks such as Accenture at one point trading as low as one cent amid a dearth of liquidity.
Pause harmony
Leading US exchanges have said that in discussions with the Securities and Exchange Commission they will probably harmonise their mechanisms to pause trading in volatile periods.
The New York Stock Exchange, whose Liquidity Refreshment Point programme halts trading, and Nasdaq, which uses Volatility Guard, say they may withdraw those mechanisms when the SEC finalises market-wide pause rules.
The move reflects efforts by the industry to improve the infrastructure of US equity trading.
There is still intense debate about how to tackle that withdrawal of liquidity. “There is no silver bullet, but to prevent another, new kind of May 6, we’re strong advocates of additional tools like clarifying rules to explicitly state obligations and benefits for bonafide market making,” says Mr McCarthy.
Some say withdrawals from the market are inevitable no matter what changes are introduced. “It is tough to expect someone to step in front of a freight train coming at them,” says Sang Lee, analyst at the Aite Group.
In the meantime, several of the SEC’s safeguards, as well as some of those recently introduced by private operators, could lead to more technological complexity, which in turn could create its own problems, says Alison Crosthwait at brokerage Instinet.
“It means that every firm that builds algorithms has to get really granular. It gets very complicated very quickly, and it’s hard to build strategies and trade efficiently,” she says.
Regulators have discussed creating rules for monitoring algorithms, the computer programmes used by high-frequency traders to deal in fractions of a second, which contributed to the rapid acceleration in selling last May. But these are still in their infancy. While the broader market has not seen a repeat of those 20 calamitous minutes, trading irregularities of one sort or another still occur.
Last week trades in more than 80 stocks and exchange-traded funds on the Nasdaq had to be broken because of a glitch in the system that provides automated quotes for market makers. This week a customer error led to sharp drops in Nasdaq and New York Stock Exchange-listed companies in the after-hours market.
“In a world dominated by technology, there will always be unforeseen technology errors,” says Eric Noll at Nasdaq. “What we should be doing is making sure we have mechanisms in place to make sure those problems don’t cause any serious damage.”
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