Who knew that a drop in the Dow on May 6, 2010, would lead to a T-shirt emblazoned with “I survived the crash of 2:45 pm.”? James Allen, head of capital markets policy at the CFA Institute in Charlottesville, Va., certainly didn’t. But he found out about the “Flash Crash” soon enough.
Allen was on a conference call with industry colleagues when he got the news. “This gentleman from Texas said, ‘Hey, do you guys see what’s going on in this market? I gotta go. Bye.’ Click. And the call ended,” Allen recalls.
The Flash Crash was a steep plunge in the Dow Jones Industrial Average, triggering a decline of about 5% across North American markets within mere minutes. “You had a dearth of buying interest compared to massive selling interest,” explains Allen, adding that this was a result of the activities of a number of different market players.
Computerized trading allows high-frequency traders (HFTs)—who trade quickly and sell aggressively—to take advantage of pricing anomalies, making it difficult for fund managers interested in investing for the long term, he says. HFTs also have many of the same privileges as market makers (i.e., direct access to the exchange servers). But the real problem, according to Allen, is an “uneven regulatory playing field.”
Even before the Flash Crash, the U.S. Securities and Exchange Commission (SEC) proposed a “trade at” rule, requiring broker-dealers to post an offer (whether buying or selling) in the market for a period of time prior to being able to transact at that price. Allen sees this as a complex solution to a complex problem. “We’re arguing to do away with different parties operating under different rules.”
If a broker-dealer is acting as an “internalization crossing network” (or internalizer) for its clients, it’s executing trades just as the NASDAQ does, for example, he explains. The difference is that the broker-dealer executes these trades internally, without sending the orders to the exchanges where they might get better pricing. “Those entities should be operating under the same rule books so that you don’t have disparities of one group over the other.”
To prevent future Flash Crashes, on June 10, 2010, the SEC approved rules known as “circuit breakers,” requiring exchanges to pause trading in certain stocks if the price moves 10% or more in a five-minute period. “They let the buys catch up with the sells,” Allen adds.
But these circuit breakers aren’t foolproof. Allen likens them to those found in your home. “You want them to trip if there’s a surge. However, if they continue to trip, there’s something wrong with your electrical system.”
Since the Flash Crash last May, there have been a number of smaller incidences. Allen sees the new rules as a step in the right direction but insufficient to address the larger “wiring issue.” “It’s curing the symptom not the disease.”