Top industry leaders and regulators are still trying to figure out what happened during the mysterious "flash crash" of May 6, when the Dow dropped 1,000 points and exchanges briefly fell off a cliff.
While most or all of the erroneous trades in stocks and exchange-traded funds that took place between 2:40 p.m. and 3 p.m. that day have been canceled, more than 100 ETFs fell to mere pennies and then rebounded. Fund leaders are worried about what could have happened had this apparent glitch occurred an hour later.
If the crash had occurred at the end of the trading day, not only could it have wiped out investors' holdings, it could also have been a pricing nightmare for mutual funds, said David Ruder, former chairman of the Securities and Exchange Commission and the William W. Gurley Memorial Professor of Law Emeritus at Northwestern University School of Law in Chicago.
"Mutual fund managers are quite right to be concerned about volatility," Ruder told MME. "What's particularly interesting is that the spikes in price didn't happen at the end of the day. Had they occurred at the end of the day when mutual funds calculate their daily net asset values, it really could have caused some problems."
The SEC and the Commodity Futures Trading Commission have created a joint panel to study the recent volatility as well as other emerging regulatory issues. SEC Chairman Mary Schapiro and CFTC Chairman Gary Gensler will serve as co-chairs of the new Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues. Former Vanguard Charman and CEO Jack Brennan, who led last year's Money Fund Working Group to provide timely analysis and recommendations on money market fund reforms, is also on the panel.
The committee was devised last year as part of the agencies' harmonization efforts and unveiled last week.
Ruder was on the short list of regulators, former regulators, law professors and financial industry experts picked for the joint committee.
The market dive was déjà vu for Ruder, who also chaired the Mutual Fund Directors Forum for a decade and was chairman of the SEC during Black Monday on Oct. 19, 1987, when the Dow fell nearly 23% in a single day. Ruder supervised enforcement actions in the aftermath of that crisis, including the creation of anti-fraud laws and the expansion of international securities regulations.
Ruder said he is looking forward to getting information from the SEC staff and working with the other committee members to figure out what triggered the free-fall.
"How could it have happened? Why did certain stocks and ETFs decline as much as they did? We will be looking at [the May 6] events and asking the same questions," Ruder said.
Other members of the joint committee-which is still being formed-include Brooksley Born, the former chair of the CFTC; Robert Engle, the Michael Armellino Professor of Finance at the NYU Stern School of Business; Richard Ketchum, chairman and CEO of FINRA; Maureen O'Hara, professor of management and finance at Cornell University; and Susan Phillips, dean and professor of finance at The George Washington University School of Business.
For a white-knuckled 17 minutes, markets went haywire. The facts are still coming in, but it appears investigators can rule out rumors of a "fat-finger" typo, unusual trading in Proctor & Gamble stock, or a terrorist/hacker attack. Much more likely is that a tiny glitch somewhere in our incredibly fast, incredibly complex and interconnected electronic trading systems caused markets to spiral out of control at breakneck speed and then self-correct just as quickly.
"The interconnections among markets and among equity securities and derivatives have grown immensely more complex over the past few years," Schapiro said last week in testimony before the House Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises. "Orders in one stock directed to one market can now ricochet to other markets and trigger algorithmic executions in other stocks and derivatives in milliseconds."
Most ETFs were only moderately affected by the price swings, although several dozen dropped to a penny or less for a brief moment, according to data from Morningstar.
The iShares Russell 1000 Growth Index ETF briefly fell from $51.75 to $0.01, the iShares Russell 3000 Index ETF fell from $70.03 to $0.01, and the SPDR S&P International Dividend ETF went from $53.98 to zero, before recovering. Morningstar said more than 200 erroneous ETF trades were cancelled on March 6.
Schapiro said a practice known as "stub quoting" could be the cause for why so many valuable stocks were briefly priced at pennies. She said a stub quote is essentially a default place holder that is triggered when a market maker's liquidity has been exhausted.
"At this point, the root cause of the sudden disappearance of liquidity in many stocks is unclear," Schapiro continued. "One potential explanation is the inherent nature of algorithmic liquidity providers."
Algorithms are typically based on historical trading conditions and patterns and are programmed to respond to events at incredibly fast speeds, without human interaction.
"Automated trading systems will follow their coded logic regardless of outcome, while human involvement likely would have prevented these orders from executing at absurd prices," she said. "Algorithms may be very effective in adding liquidity in normal trading conditions, but may be inherently ineffective in adding liquidity when dealing with highly unusual events such as occurred on May 6."
Better Circuit Breakers
"Our markets need a pre-established and coordinated way to respond to extreme, rapid market volatility," said Larry Leibowitz, chief operating officer of NYSE Euronext, in testimony following Schapiro's.
Leibowitz said improved market-wide circuit breakers are needed, in addition to the existing system of liquidity replenishing points.
"Current market-wide circuit breakers were established long ago and are based on market moves of 10%, 20% and 30%," he said. "There has not been a move greater than 10% in a single day, post 2000. These levels will be tightened and the circuit breaker will be based on a broader index, rather than a narrow Dow Jones index."
Schapiro said the SEC is developing improved market circuit breakers, as well as a consolidated audit trail to help track trading activity in real time. The SEC will consider proposals on these issues in the coming weeks, she said.
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