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'Flash Crash' Less Likely to Happen in Europe?

Tuesday, 22 Jun 2010 | 2:58 AM ET

Tighter regulation and fewer alternative trading venues make it less likely that a "flash crash" like the one that briefly erased $1 trillion in market value on Wall Street last month would be repeated in Europe, stock exchange officials and traders told CNBC.com.

AP

But other market experts expressed concerns that Europe is just as exposed to such events, since global markets are closely linked.

And some are worried that on Wall Street, the flash crash can be repeated any time.

A crash like the one on May 6 "would not happen in Europe," according to Michael Krogmann , head of department of Xetra Market Development, Institutional Equity at Deutsche Börse.

"The Deutsche Borse is the reference market. Other markets don't trade when we go into auction because there's no liquidity," Krogmann said.

When market goes into "auction mode," no trades can be executed for several minutes. Investors are given time to determine whether there is anything substantial behind market volatility.

While auctions occur during volatile periods in both the US and Europe, the methods by which trading is stopped differ.

In Germany, "(w)e have a volatility stop, which stops trading after a certain fall, a percentage or point value that is determined by the exchange. No one (outside the exchange) knows what this is," Oliver Roth, head of specialist floor equities at the Frankfurt Stock Exchange, said.

In New York, on the other hand, the triggers to launch auction mode in trading are precise. Crucially, for a 10 percent drop, the New York Stock Exchange doesn't halt trading at all after 2:30 pm.

Many industry experts find it unusual that the May 6 volatility happened only 10 minutes after this close, at 2:40 pm, a time when a 1,000-point drop wouldn't force the market into auction.

"I seriously doubt such a situation like New York could happen in Germany," Roth said. Euronext, the Deutsche Börse and the London Stock Exchange all have similar circuit-breakers, which would be activated at any time of day if the volatility was high enough.

Europe Is No Haven

But other experts argued that a "flash crash" in Europe could easily occur. "The crash could happen in Europe," Laura Smith, fixed income sales trader at Mako, said. "You have a lot of (high-frequency) trading here as well. But it's less likely to happen in Europe, because the continent lacks the 'multi-venue' characteristic of the states."

High-frequency trading, or HFT, refers to the trading of stocks at extremely fast speeds with the help of computers.

"Why should Europe escape a flash crash? The markets are as interlinked as they've ever been and if it can happen in the States it can certainly happen here," Lane Clark, managing director at Beta 2, a London-based trading company, said.

"Every factor that started the flash crash in the US in the first place, and then gave it some more momentum exists here," Clark added. "Whether it's multiple trading venues, different algorithms, automated trading, or 'fat fingers' syndrome- Europe has it too."

Algorithmic trading is a process where a computer algorithm decides what to trade and executes this without human intervention. "Fat-finger" syndrome refers to the rare, but risky slip where traders press the wrong button and lose money as a result.

While experts admit there's a small chance of a "flash crash" happening in Europe, most think this probability is lower than in America because there are fewer alternative trading venues, or MTFs.

An MTF, or Multilateral Trading Facility, is a privately-organized electronic trading platform that is not publically regulated.

They are often owned by the investment banks that execute hundreds of millions of trades on them. Instinet, for example, is a subsidiary of Nomura Holdings. Bats global markets is owned almost entirely by the following: Bank of America Merrill Lynch, Citigroup, Credit Suisse, Deutsche Bank, Getco, JPMorgan Chase, Lime, Morgan Stanley and Wedbush.

Non-Regulated Platforms

Primary exchanges are losing market share to MTFs at a blinding pace.

Research carried out by The Tower Group in 2008 found that costs incurred from executing on Chi-X Europe were five times cheaper than trading on the London Stock Exchange (LSE) and more than ten times cheaper than trading on Deutsche Börse or NYSE Euronext.

"Non-regulated trading platforms are the problem. The flow has gone from Wall Street to MTFs," Roth said.

Fund managers argue that greater number of alternative trading venues is helping to promote deeper, more liquid markets. But the fact that not all exchanges are subject to the same rules has caused concern.

The Securities and Exchange Commission and the Commodities Futures Trading Commission released a joint report on May 18 with preliminary findings regarding the "flash crash," that "the liquidity mismatch may have been exacerbated by disparate trading conventions among various exchanges."

MTFs do exist in the European Union, but there are fewer of them, and "they tend to be more closely pegged to the major exchanges," Smith said.

Chi-X Europe, for instance, uses "order entry controls" that prevent orders being entered that are more than 20 per cent away from the LSE trade price, as well as the prices on other European venues.

In late May, Duncan Neiderauer, CEO of the New York Stock Exchange, said in the Financial Times that, "In most developed markets, there is one 'national' exchange on which public companies can list their stock." But "in the US, there is more than one listings platform and no fewer than 40 trading venues," Neiderauer said.

"Many are insufficiently transparent, and most investors have little knowledge or influence over where their trades are executed."

Tighter Regulation?

Another reason that the propensity to "flash crash" may be lower in Europe is that the rules regarding electronic trading are somewhat weaker in America, and the new regulations proposed by the SEC would only bring the US up to speed with what has long existed in Europe.

"The circuit breakers in place at NYSE have been watered down since the original ones were put in place following 1987 crash, and the new Alternative Trading Systems including Dark Pool trading (under Rule NMS which took effect in 2007) do not have the circuit breakers at all," Randall Dodd, director of the Derivatives Study Center in Washington, said.

In response to the crash, the SEC passed a law that will require national exchanges to pause in trading if the price moves 10 percent or more in a five-minute period.

The curbs will run across NYSE Euronext, Nasdaq, Bats Trading and Direct Edge, the four main US stock exchanges.

But they will not affect dozens of other electronic trading platforms.

The new law will only cover stocks within the S&P 500 index, and it doesn't cover smaller-cap stocks or index-based products such as exchange-traded funds, which were some of the stocks most dramatically affected on May 6.

But any new regulation could face tough opposition. "These people are very mighty, (the) largest hedge funds, investment banks. They have a lot of money out of it, and they don't want it changed." Roth said.

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