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SEC Takes Initial Measures to Avoid a Second Flash Crash

Expert Witness: Fulcrum Inquiry
We explain high-frequency trading that likely caused the crash, and the additional regulatory changes that will be seriously considered.

The “flash crash” on May 6, 2010 is the biggest one-day intraday decline in Dow Jones Industrial Average history. The "flash crash" saw the Dow Jones Industrial Average plummet almost 1,000 points before partially recovering.

Both the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission told a Senate banking committee that they had not yet found the reasons why the U.S. stock market plunged and rebounded in this manner. At this point, most believe a definitive answer will never be known. However, the leading culprit for the crash is the cancellation of existing buy orders from
high speed trading when the computers identified market disequilibrium. The removal of this normal trading activity caused other computer-driven trading to allow prices at unexpected and undeserved levels. For example, during the flash crash, stop-loss orders were triggered at executed prices far below what the instructions anticipated. The stop-loss orders provided fuel for panic selling at a time when there were no purchasers.

After markets closed May 6, the NASDAQ Stock Market issued a six-page list of companies whose stocks were affected by the 20-minute long "flash crash." All trades that took place in that period were canceled by NASDAQ. The electronic-trading platform owned by the NYSE also reversed a large number of trades. Effectively, the exchanges cancelled trades executed in a 20-minute time frame that deviated more than 60 percent from the stock's last published price.

An Explanation of High-Frequency Trading

Today, most orders are routed for execution through high-speed, high-volume, automated algorithmic trading. Without human intervention, an electronic stock market (called an ECN for Electronic Communication Network) takes orders to buy or sell securities, matches them with a party willing to take the other side of that trade, and then executes the transaction. Regulation NMS (an abbreviation for National Market System) requires that an ECN must go to other markets to see whether there is a better price for any order.

Broker-dealers are regulated by (i) federal securities laws, (ii) the rules of the self-regulatory organizations, (like FINRA) and (iii) the rules of the exchanges to which they have access. Broker-dealers have direct electronic access to their selected stock exchanges.

Some sophisticated customers have created their own trading programs and are executing high-speed trades themselves. This is accomplished by bypassing the broker-dealer by using their broker’s identification codes. When the customer receives access to an exchange using the broker-dealer’s identification code, the arrangement is known as “direct market access” or “sponsored access.” In these arrangements, the unregulated customer places orders directly into the markets without first passing through the broker-dealer’s systems or otherwise being pre-screened by the broker-dealer. This type of direct market access is known as “unfiltered” access and “naked” access.

Well before the flash crash, the SEC focused on trading vulnerabilities involving high-frequency trading using naked access. High-frequency trading is a subset of computer-assisted trading that uses extremely fast speeds with the help of powerful computers. Using complex algorithms, these computers scan public and private marketplaces, execute millions of orders a second, and alter strategies within milliseconds. In the U.S., high-frequency trading firms represent 2.0% of the approximately 20,000 firms operating today, but account for approximately three quarters of all equity trading volume.

The SEC said information from these trading-center data feeds "can reach end-users faster than the consolidated data feeds." This makes it possible to arbitrage trade (some would suggest cheat or game) the national best bid and ask price on a stock. Knowing (even for a few milliseconds) price moves ahead of the national best bid and offer price allows the trader to make guaranteed profits so long as one can trade on that information fast enough.

For example, let's assume that a buyer enters a buy order for a stock at a $10 limit price per share. The latest and best market price quoted at that time is $9.95, meaning the buyer is willing to pay 5 cents more per share than what is on the national system at that instant. Some markets, like NASDAQ, allows certain high-frequency traders to see offered transactions for around 30 milliseconds (a millisecond is one-thousands of a second) before the transaction is shown to the broad marketplace, and then execute on this information. This practice is called flash trading.

Traders with this preferred access (and the related computers necessary to implement transactions this quickly) would take our hypothetical $10 transaction with the knowledge that profit can be made. Although the profit on each trade is small, this is repeated millions of times a day. Under other circumstances, our hypothetical buyer would have the opportunity to see the sell order at the lower price and might subsequently drop the limit price on his limit buy order. However, high-frequency trading computers are so fast that unless the buyer owned comparable machines, he would have no knowledge of or chance to do this.

According to the Tabb Group, high-frequency traders generated about $21 billion in profits in 2008.

The SEC’s Response So Far, Plus Future Expected Action

High-frequency traders try to keep what is known as a balanced book, meaning they do not wish to hold open stock positions for more than a few moments. Stated otherwise, the number of buy transactions must always equal the number of sell transactions. Should the book become unbalanced, the high-frequency trader will stop trading. This appears to be the leading explanation for what caused the flash crash. All this so-called liquidity, which generally makes it possible for buyers and sellers to meet, suddenly disappeared when the high-frequency traders' books became imbalanced. Consequently, the high-frequency traders stopped trading, the liquidity dried up, and the market plunged.

Allowing preferred access has been justified based on high-frequency traders providing additional liquidity to the markets. While liquidity is a good thing, liquidity is not a justification for anyone obtaining guaranteed profits through preferred access. Nevertheless, the flash crash demonstrated that, when liquidity was needed, no liquidity was actually provided because the firms with the necessary access stopped all trading.

On January 13, 2010, the SEC’s 74-page "concept release," on trading and market structure sought public comment on the fairness and stability of U.S. equity markets. The SEC paper included issues involving high frequency trading, co-locating trading terminals, and markets that do not publicly display price quotations. Based on the rationale in this paper, on September 17, 2009 (before the flash crash), the SEC commissioners unanimously voted to seek public comment on a rule barring exchanges and trading platforms from giving clients access to information about stock orders a fraction of a second before the market. Effectively, the SEC would ban naked access and require more supervision of unlicensed traders. The proposal requires a second vote at a later public meeting to become binding.

Unless someone comes up with a better solution to avoid another flash crash, it would seem almost certain that this proposal to stop naked access will become final. In the words of SEC Chair Mary Shapiro, “If active trading firms exploited their superior trading resources and significantly contributed to the severe price swings on May 6, we must consider whether regulatory action is needed to address the problem.”

So far, after the flash crash, the SEC has taken the following measures:

1. On May 26, 2010, the SEC proposed a rule that would require the exchanges to establish a consolidated audit trail system that would enable regulators to obtain information about orders received and executed. Currently, there is no single database of comprehensive and readily accessible data regarding orders and executions. The additional information would help regulators keep pace with new technology and trading patterns.

2. On June 10, the SEC approved new rules designed to tame the volatility of individual stocks by temporarily halting trading during dramatic price changes. All exchanges will now halt trading for five minutes in an individual stock when its price moves 10% or more (whether up or down) in the previous five minutes. The pause is designed to give traders time to assess whether a stock's price change stems from a real shift in value or an unrelated market hiccup. The financial industry generally supports the new circuit breaker rule.

Right now, the circuit breaker applies only to stocks contained in Standard & Poor's 500-stock index, although an expansion of the system is likely. Additionally, the rule applies only from 9:45 a.m. to 3:45 p.m. EDT. Trades placed overnight to be executed at the market open, and trades made right before the market close will be vulnerable for the 15-minute periods when the rule is not in effect.

On June 2, 2010, the SEC held a roundtable meeting as part of gathering input on (i) the SEC’s “concept release” described above, and (ii) the over 200 letters the SEC received in response. The June 2 meeting was scheduled before the flash crash, but the flash crash gave the gathering added importance. Most regulators agree that the new circuit breaker rules alone won't stop another flash crash from occurring. The flash crash was sufficiently embarrassing and disruptive that additional proposals are now being more seriously considered. Some of the additional changes we may now see include:

1. High frequency traded is aided by the ability to quickly cancel orders when market transactions change. Some estimate that over 90% of the possible high frequency trades are cancelled. The ability to profit from high frequency trades would be limited by a rule that requires traders to execute trades without cancellation, or more modestly, allow cancellation only after a specified period.

2. Limitations placed on so-called stub quotes, which are standing orders well off the reasonable price of a stock. Many of these small-price buy orders were executed during the flash crash for as little as a penny. Market orders and stop-loss selling could also see new limitations.

3. Clear rules for rescinding trades, which would eliminate confusion when things go awry. As noted above, the exchanges decided to cancel certain trades occurring during the flash crash, but there was little pre-existing authority for how cancellations should be determined and executed.

The public stock and bond markets’ purpose is to assist raising long-term capital for businesses, thereby lowering the cost of that capital. SEC Chair Mary Shapiro properly noted that the trading rules should ensure that the interests of long-term investors are preserved. The changes being proposed will hurt the profits of short-term traders, but such traders do little if anything to advance these agreed-upon long-term purposes.

Mr. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials: CPA, MBA, CMA and ASA.

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Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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