Happy fourth anniversary, Flash Crash! Don't expect bold action from the SEC.
I was on the air on the trading desk of BTIG on the morning of May 6, 2010, interviewing sports stars for a charity event, when the rolling Flash Crash started.
There seems to have been many "causes" of the Flash Crash, including 1) great worries about the stability of Europe, particularly Greece, 2) a very large institutional algorithmic order on the E-mini market, which the SEC found to be the primary factor, and 3) delays in data dissemination of consolidated trade and quote information, which caused many high-frequency and algorithmic traders to cancel their bids and offers.
The official SEC report blamed all of the above, and threw in the fragmented nature of the stock market as well.
Whatever the cause, there were a number of changes made that have greatly helped stabilize the market:
- The most important event was creation of system-wide individual stock circuit breakers, including more refined "limit up/limit down" rules, which halted trading for five minutes when stocks moved more than a certain percentage (depending on the stock price) in a rolling five minute period;
- clearer rules were enacted as to which trades will be broken when there were unusual price movements;
- minimum quoting requirements were implemented that eliminated "stub quotes," which were minimum bid and offer prices (often as low as $0.01 for a bid) that served as minimum requirements for market makers. During the Flash Crash, many of these "stub quotes" were hit, even though they were never intended to be.
- the S&P 500 replaced the Dow Jones Industrial Average as a market-wide circuit breaker. The S&P is a broader index. The thresholds for initial halts were changed from 10 percent on the Dow to seven percent on the S&P.
Have the changes implemented since then been effective? For the most part, I would say yes. Limit up/limit down has been very effective dampening volatility.
However, it's not perfect. We are still seeing individual stock "mini-crashes" that pop up. One possibility to combat that is a tighter "collar," say halting trading when a stock moves five percent rather than 10 percent in a given period.
Or perhaps we should just demand more vigilance from market makers to make sure they step in to avoid these crashes, which usually take place in a matter of seconds, then self-correct.
Or--here's a radical thought--improve the obligations of market makers in general, including clarifying what--if any--market maker obligations high-frequency trading firms should have.
But don't kid yourself--having market maker obligations by floor specialists at the NYSE or NASDAQ market makers did not prevent big market drops in the past.
Another possibility is to change the market structure. There are 13 stock exchanges, and over 40 dark pools. That's a lot of complexity. Markets would be more stable with fewer places to trade.
Will that happen? Not likely, at least not immediately.
And while I'm on the subject of market structure, what if anything will the SEC be doing in response to Michael Lewis' "Flash Boys" book?
My hunch: Not much, at least not immediately.
One idea I have reported on before seems to have traction: A limited program that would require dark pools and other alternative trading systems to provide meaningful price improvement to the best bid and offer. This "trade-at rule" would likely be part of a pilot program that would be tested at first with a handful of small company stocks.
Why? The SEC has already expressed interest in examining why roughly 40 percent of U.S. trading has been driven to dark pools. After the Flash Crash, the CFTC and the SEC established an The Advisory Committee on Emerging Regulatory Issues that was designed to make suggestions on improving market structure. They expressed some concern over dark pools and internalization in general and suggested that the SEC consider adopting a rule that dark pools and internalizers should only be allowed to execute at prices that are superior to the best bid and offer.
Still, it's a pretty modest proposal.
What will not happen any time soon: Broad, sweeping changes in market structure. No "we are banning high-frequency trading!" No "we are banning payment for order flow and rebates."
Why not? Because neither the SEC nor the Commodities Futures Trading Commission (CFTC), which regulates the futures markets, is convinced there is a need for such broad action. They like competition between markets. They like that spreads have never been narrower. They are not going to go back to the NYSE and NASDAQ ruling the whole world.
They are also terrified of the law of unintended consequences, that making sweeping changes without careful deliberation could make matters even worse.
After all, they studied making changes that culminated in Reg NMS for years before it came into effect in 2007. They have spent several years just watching the effects of what they did.
Besides, the SEC still a lot on its plate, specifically the Dodd-Frank agenda, where they have just finished writing over 1,000 pages of rules.
Add to the fact that they remain significantly underfunded given their mandate, and you can see why they are reluctant to plunge ahead with bold "reforms."