Ted Kaufman - United States Senator for Delaware

June 1, 2010

When James Angel wrote to the Securities and Exchange Commission just over a month ago, he made a prescient point. “With so much activity driven by automated computer systems, there is a risk that something will go extremely wrong at high speed,” the associate professor of finance at Georgetown University warned the US equity market’s main regulator in a letter sent on April 30.

It took only six days for the prediction to come true.

On May 6, a Thursday, the mood on Wall Street was already negative: concerns about the Greek sovereign debt crisis and its impact on the euro meant US stocks were already down by about 5 per cent. But within seconds, just after 2.40pm, those falls had doubled or more. Shares in Procter & Gamble, the household products giant, fell 35 per cent; those of Accenture, the consulting group, slid precipitately from $40 per share to trade at the incredible price of just one cent.

Traders were stunned. “We thought a big European bank was about to go under, that this was it,” says a dealer who was on one of the big trading floors at the time. “Everyone got on the phone. Then, traders quickly realised that the falls were due to lots of automated sell orders. At that point we all just wanted to reach for the emergency button and press stop.”

While there have been times in equity markets where some stocks have moved wildly, the afternoon that has become known as the “flash crash” was the first time that the entire US equity market was convulsed by such turmoil.

But 20 minutes later prices had bounced back. Trades that took place during that dramatic slice of the hour where the movement was more than 60 per cent were cancelled. Yet the impact of the flash crash will be felt for a long time to come, not least because it showed that the equity markets do not have such an emergency button, or any way to halt trading when something goes haywire.

“The decline and rebound of prices in major market indices and individual securities on May 6 was unprecedented in its speed and scope,” said the SEC in a report on the saga. “The whipsawing prices resulted in investors selling at losses during the decline and undermined confidence in the markets.”

On Wednesday, the regulator is hosting a day-long Washington debate on the topic, involving many leading industry participants. “All market reform will be looked at through the prism of what happened on May 6,” says William O’Brien, chief executive of DirectEdge, one of the four main public exchanges for US shares.

The gathering comes as the issue of how markets function also rises up the agenda in Europe, where the German cabinet on Thursday meets to discuss proposals to ban so-called “naked” short-selling in German stocks – offering securities that one neither owns nor has agreed to borrow – as well as a ban on speculative derivatives on the 16-nation euro currency. In Brussels, the European Commission, the European Union’s executive arm, is preparing a review of the liberalisation it introduced in share trading three years ago.

Yet amid all this activity, it is still unknown exactly what sparked the breakdown in US share trading on that otherwise unremarkable Thursday. The search to answer this mystery is in full swing, with regulators ploughing through thousands of spreadsheets and tracking more than 19bn trades in equity and derivatives markets in the search for clues.

One thing has been established: the SEC says it has found no evidence yet that the crash was the result either of “fat finger” errors, when a trader presses the wrong key or magnifies an order by misplacing a decimal point, or of computer hacking or terrorism.

“The real shocker is that it was nothing nefarious that caused the crash,” says David Weild, senior adviser to Grant Thornton and former vice-chairman at Nasdaq. “It was acceptable investor behaviour – people trying to put on hedge transactions,” he believes. “The market had a mini-meltdown in an instance when it appears no one was intentionally trying to manipulate the market. It’s disturbing that it does not take a lot to cause these markets to cascade.”

The ongoing autopsy of the US flash crash has implications way beyond Wall Street. Markets across the globe – particularly those that trade privately instead of through exchanges – are under intense scrutiny.

Opacity in privately traded markets, such as in derivatives and complex securitised bonds, is widely seen as having contributed to the meltdown of the financial system in 2008 and the ensuing global economic crisis. Laws are being passed across the globe to force over-the-counter derivatives and other markets into the public eye.

In many cases, stock markets have been hailed as the standard to live up to, for the ease with which investors can check stock prices and trade shares even when markets are volatile. “Our current equity markets are characterised by efficient and effective linkages and healthy competition among markets and market participants,” said the Securities Industry Financial Markets Association, which represents many large banks and brokers, in a letter to the SEC, also penned on April 30.

During the 2008 financial crisis, trading in the equity markets “continued without a significant hitch”, Sifma points out. “This is in contrast to the liquidity freezes and instability that were evident in other markets (ie, the credit markets) during that time.”

But the flash crash confirmed the suspicions of those investors and regulators who had long worried that complicated trading systems, fragmented trading across some 40 different venues, and the enthusiastic embrace of super-fast trading with computers spitting out thousands of buy and sell orders in microseconds, could threaten disaster.

Indeed, the flash crash taps into a debate that has been simmering for years between those who see benefits created by the rapid advance of technology – by lowering barriers to entry for new participants and boosting liquidity for investors who wish to trade – and those who fear it has introduced unknown risks into the system.

The events of May 6 revealed that while getting rid of old-style “specialist” market makers has reduced the cost of trading by narrowing bid-ask spreads, the benefit has come at a cost. Now, no one has an obligation to provide prices for all shares all the time during a trading day, as trading has fragmented across an array of electronic trading venues and traders. The moment the markets grow too risky, many new electronic market makers appear only too willing to head for the exit.

Stitching venues together is a dazzling new way of trading that has become the engine for profits for many of the biggest exchanges and trading houses, powered by rapid-fire computer programs. Trades can be executed as fast as 250 microseconds – hundreds of times faster than the blink of a human eye.

Trading volumes have soared as a new species, the high-frequency trader, has emerged – their computers spitting out thousands of prices and trading constantly during the day before retiring at the closing bell without, more often than not, holding any stocks.

This shift is not unique to the equities business. Technology has changed many other big markets around the world and also tied them more closely together. High-frequency trading is an increasing feature in the currency, bond and commodity markets. Hedge funds and other investors shift both within these markets and between them. Trading strategies can adapt with ease.

Such changes have created winners and losers. Traditional brokerages have been forced to upgrade their technology and mourn the loss of bigger trading margins from buying and selling shares. Both the New York Stock Exchange and Nasdaq have ceded market share and influence to Bats Exchange and DirectEdge, the new upstart exchanges that have captured about 20 per cent of trading volumes.

Against this backdrop, the SEC in January launched a broad review of the structure of US equity markets. The aim was to assess whether the ability of some types of traders with short-term horizons to deploy sophisticated technology might put longer-term investors at a disadvantage; whether the dispersal of liquidity across multiple trading venues meant there was any longer a “unified national market system”; and whether more rules and regulations were needed.

The debate is not unique to equity markets, nor to the US. In Europe, concern over how market structures function is just as intense – and opinions just as polarised. Fragmentation between multiple trading venues – a feature of the US landscape for a decade – did not arrive in Europe until 2007, when rules enacted by the European Commission broke the monopolies of established exchanges such as the London Stock Exchange and Deutsche Börse.

The Markets in Financial Instruments Directive unleashed a wave of competition from new trading platforms. That has led to a confusing picture for investors, made worse by the lack of a US-style national price quoting system – known as a “consolidated tape”.

Brussels is about to launch its first review of Mifid, with preparatory work being done by the Committee of European Securities Regulators – just as the US is in the midst of its review. This week, the Paris-based CESR will start studying dozens of comments sent in by market participants.

But the scope of CESR’s work – and therefore the eventual Mifid review – has expanded far beyond a routine taking of the temperature, as Europe has had to cope with the consequences of the same technology revolution that swept the US. CESR now says it needs to assess issues such as high-frequency trading “in greater depth due to their potential effects on overall equity market structure”.

It is doing so amid concern that a flash crash – and perhaps one without so rapid a rebound as was seen on Wall Street last month – may come to be not solely an American phenomenon. Christian Katz, chief executive of the Swiss stock exchange, says bluntly: “This flash crash could be possible in Europe.” What is more, he points to gaps in co-ordination that might exacerbate that sort of seizure were it to happen. “We cannot guarantee that when we halt trading [in extreme conditions on the Swiss exchange], the same happens on other venues. We should adopt some minimum level of safety systems.”

As the debate intensifies, there is growing anxiety that the interests of the big banks and the exchanges are not the same as the interests of investors – a theme that runs through regulators’ efforts to reform derivatives and other markets too.

After the flash crash, exchange heads met SEC officials and efforts are afoot to restore trust. Circuit breakers, aimed at stopping dealings if the algorithms that drive high-frequency trading spiral out of control, are due to kick in next week.

But Edward KAUFMAN, a Democratic senator who has repeatedly warned about the dangers of high-frequency trading, says the industry has so far co-operated only “in finding Band-Aid solutions”. He argues: “We may need further action, probably against the interests of those who benefit from the current market design,” adding that “regulators are dependent almost exclusively for the information and evidence they receive about market problems on the very market participants they are supposed to be confronting about needed changes.”

A survey by Tabb Group, a consultancy, taken ahead of Wednesday’s SEC meeting, highlights the divergence of views. It found that 62 per cent of survey respondents on the “buy side” – those with money to invest – were negative towards high-frequency trading after the flash crash. Banks on the “sell side” and exchanges remained positive in their views, the survey discovered.

Adam Sussman, Tabb’s director of research, finds that worrying. “This is particularly demoralising, given that the buy side are guardians over much of the equity investments in the US,” Mr Sussman says.

Whatever the outcome of the debate, the experiences of May 6 confirm that machines are too fast for humans to keep up with – meaning that safety catches need to be automated too. As Mr Angel from Georgetown wrote to the SEC: “In the minute or so it takes for humans to respond to machine meltdown, billions of dollars of damages could occur.”

Stop lights on the way

“Circuit-breakers” intended to prevent the kind of rout seen briefly in the May 6 “flash crash” will be introduced next week for stocks in the Standard & Poor’s 500 index. If prices move by 10 per cent or more – up or down – compared with those recorded in the preceding five minutes, trading will be temporarily halted. Significantly, the curbs will apply to all exchanges and platforms on which S&P 500 shares are traded. While similar measures are already in place on the floor of the New York Stock Exchange, for example, they have not so far applied to the whole market. 

REGULATORY TECHNOLOGY

The fax is not dead: why collecting data is still an everyday struggle

Collecting data by fax may seem hopelessly 20th-century in an age when trading is conducted hundreds of times faster than the blink of an eye, writes Jeremy Grant.

But that is how Scott O’Malia, a commissioner at the US Commodity Futures Trading Commission, recently said his agency was still gathering certain kinds of information from traders. When futures brokers open accounts on behalf of clients, they fax required details to the CFTC. The same applies when so-called “large trader” data are sent in by other kinds of market participants.

For Mr O’Malia, it shows how the regulator has been in a “perpetual game of technological catch-up” when it comes to monitoring the derivatives markets. That same game is being played out across the globe as market regulators scramble to close the gap that has opened up between them and the markets they oversee.

As Mary Schapiro, chairman of the US Securities and Exchange Commission, puts it: “The technology for collecting data and surveilling our markets is often as much as two decades behind the technology currently used by those we regulate. As a result, there is an intense need for regulators to have efficient access to a far more robust and effective cross-market order and execution tracking system.”

On May 6, the day of the “flash crash”, more than 19bn shares were traded across multiple markets, each with its own data collection approach. The task for regulators is to form a single view over all that activity by knitting together the information coming into a building where teams of people analyse the data.

Last month, the SEC proposed a rule that would set up a consolidated audit trail system, including a “central repository” to capture every share trade conducted across the multiple platforms that operate in the US.

Mr O’Malia says plenty of data come into the CFTC but the difficulty is knowing how everything fits together. “It’s not seamless yet. There is too much manual entering and cross-checking of data,” he says, adding: “What we don’t have internally is the ability to see who the beneficial owners of an account is or who the individual traders of an account is. We lack the ability to link all the various packages of information.”

Nils-Robert Persson, chairman of Cinnober, a Swedish technology company, says: “If you want to have surveillance of several markets at the same time, you have to develop new systems based on new technology, and regulators are starting to understand.”

In Britain, the Financial Services Authority receives 6m-8m “transaction reports” from trading platforms daily. If staff spot unusual share prices movements, they investigate these for potential abuse. But the FSA will soon have a system in place that will automatically alert staff to potential abuse in “real time”. Alexander Justham, the FSA’s director of markets, says the use of such “complex event processing” technology will give the FSA “a more proactive, machine-on-machine approach” to surveillance.