Wise Words From Regulators

February 23, 2011

The joint report on the ‘flash crash’ is must-reading for every investor.

It’s not often I go on the record in praise of regulation. At heart I’m a libertarian, a free-market kind of guy. Markets, however, are my edge case. Maybe I’ve just known too many traders over the years. The world is full of bad actors, and to paraphrase Willie Sutton, the markets have more than their fair share, because that’s where the money is.

I’ll admit that when I first read Regulation NMS back in 2005, I thought it was generally a good idea. On the surface, it protects the best prices on the national best bid/offer system (NBBO), prevents sub-penny trading, and cleaned up access across different exchanges. I now realize what I think the common wisdom is: NMS changed the markets in some pretty fundamental ways, bringing us high-frequency trading, dark pools, sleeping block trades and reams of sub-penny prices.

And the flash crash.

The history lesson isn’t really that important, but understanding how the markets actually work is. And perhaps the best primer on that I’ve ever read is actually the Joint CFTC-SEC Advisory Committee report on the flash crash. We covered what the committee’s findings meant for ETFs when the report came out: boosting incentives to make markets, the potential for limit-up/limit-down collars for stocks and ETFs like those we see on commodities futures.

But the real gems in here are the descriptions of how the markets are actually working that drive toward these conclusions. It’s not only smarter than most people expect from regulators—it’s better written, to boot. Read in full, it paints a crystal-clear picture of the structure and psychology of today’s markets. Here’s a sample:


“The Committee is chary of overdependence on market maker obligations as a solution to market liquidity for a number of reasons. First, even historically, these obligations were of only limited effectiveness during times of extreme volatility because the risks were simply too great. Second, given the present market maker fragmentation, we are unclear how to provide sufficient incentives to encourage meaningful change in behavior of registered market makers.”


I’ll save you the Google search:

Chary: adj

discreetly cautious: as

a: hesitant and vigilant about dangers and risks

b: slow to grant, accept, or expend

The report goes on to describe in clear prose the dismantling of the traditional market making and specialist systems in the wake of NMS, pointing out something very few folks get: “… many High Frequency Traders are not even broker-dealers and therefore their compliance with quoting requirements would have to be addressed primarily through pricing incentives.”

That’s the situation we find ourselves in. The markets are run, effectively, by unregulated private investors. When the big liquidity providers on the Street stepped away from their screens during the flash crash, they were actually doing exactly what you’d expect rational investors to do. Who in their right mind would voluntarily wade into the chaos if they had no obligation to do so?



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