Market Makers At Center Of Flash Crash Probe

February 18, 2011

The joint SEC-CFTC committee is looking for ways to keep market makers in the game.

 

Designing incentives for market makers in an era dominated by “high-frequency” electronic trading is one of the crucial challenges in today’s financial markets,  according to the latest report from U.S. securities regulators outlining ways to prevent a repeat of the “flash crash” of May 6, 2010.

About 90 percent of all trading is now done by high-speed algorithmic computer trading, Gary Gensler, the chairman of the Commodity Futures Trading Commission, said today to the joint committee of CFTC and Securities and Exchange Commission regulators who are looking into the flash crash.

Gone with people working the floors of various exchanges are many of the market makers who were personally tasked with matching buyers and sellers in particular securities—even at times of market turbulence. Indeed, on May 6, the market was flooded by sell orders, and market makers and high-frequency traders were, by and large, nowhere to be seen.

“The Committee recommends that the SEC evaluate whether incentives or regulations can be developed to encourage persons who engage in market making strategies to regularly provide buy and sell quotations that are 'reasonably related to the market,'" today’s joint report from the two regulatory agencies said.

The committee’s findings and recommendations will be critical to exchange-traded funds, which were at the heart of the May 6 "flash crash." On that day, the Dow Jones industrial average lost nearly 1,000 points, or about 10 percent, between 2:40 and 3 p.m. Eastern time, only to rebound sharply and close down 3.2 percent on the day.

ETFs, which now make up roughly a third of all equities traded in the U.S., accounted for about two-thirds of the securities whose trades were subsequently canceled.

Many ETF industry sources have told IndexUniverse.com that high-speed computer-driven trading has cut profit margins for market makers, and therefore seriously curtailed their incentives for taking on the financial risks associated with providing trading liquidity in particular securities.

The SEC-CFTC joint committee's report contains 14 recommendations, many of which have been in place on a pilot basis since the committee began its work last year. Among those are single-security circuit breakers for the large-cap stocks in the Russell 1000 Index as well as the most heavily traded ETFs.

High-Frequency Trading Still A Boon

The joint committee added, however, that high-frequency trading has been a boon for institutional as well as retail investors, and noted that the rapid, high-volume movement of capital in and out of the securities markets has lowered transaction costs and contributed, for the most part, to enhanced price discovery.

"The speed that allows markets to do things that scare us also allows markets to do things that heal quickly," said Maureen O'Hara, a professor at Cornell University's Johnson Graduate School of Management and a member of the joint committee.

"As we think about these sorts of circuit breakers and pauses, we have to recognize that just as liquidity can depart very quickly, it can come back just as fast," O’Hara said during today's joint committee meeting.

In his opening remarks, CFTC chairman Gary Gensler compared the effects of today’s high-speed algorithmic trading technology to the advent of the telegraph, which led to the ticker tape, and then the telephone. The phone allowed traders to obtain quotes instantaneously—and that was in 1929, Gensler said, stressing: "We need to adjust."

 

 

Certainty Needed On 'Broken Trades'

 

Greater certainty as to which trades will be broken in the wake of aberrant price movements was among the first recommendations the joint committee put forward in its report. Currently, the decision to cancel a trade lies within the discretion of top exchange management and federal regulators.

In the wake of the flash crash, for instance, the major securities exchanges—along with the SEC and FINRA, the financial industry's self-regulatory organization—settled on a formula for canceling so-called broken trades. They determined that any security whose share price moved 60 percent or more between 2:40 and 3:00 p.m. on May 6 was subject to the ad-hoc rule.

"In this new trading environment, market structures and regulation have to be more forward looking, with rules and regulations designed on an ex ante basis rather than an ex post basis," the joint committee said in the report.

Tapping The Brakes Using Price Collars

Instead of stomping on the brakes using hard-and-fast trading pauses based on the departure from the last good price for a security, the joint committee recommended implementing a "limit up/limit down" process that would allow trading to continue within a range of prices.

Indeed, the joint committee views the hard-stop rules in the SEC's pilot program as having a number of drawbacks.

"Specifically, their five minute duration completely restricts trading in a security even if contra-side liquidity has returned to the market."

Given the dramatic changes in the speed of the markets due to high-frequency trading, the joint committee also recommended reducing the length of circuit breaker pauses to 10 minutes and allowing them to be triggered as late as 3:30 p.m. Eastern time.

 

 

Find your next ETF

Reset All