Next week the Securities and Exchange Commission is expected to reveal the results of its investigation into May’s flash crash. It’s a pretty good bet that the SEC will not finger the real culprit: the SEC itself.
On May 6 the market went through a jarring convulsion that has come to be known as the Flash Crash. Shares of dozens of big companies plunged dramatically before recovering in a sharp upward spike. Since the crash, investors and market watchers have been trying to figure out what exactly happened.
The Flash Crash almost certainly sapped investor confidence in the stock markets. Far from looking like a reliable guide to prices for stocks, the markets appeared to be random and unrelated to actual selling or buying intentions of investors. Many blamed computer driven high-frequency trading for the crash.
It’s almost comforting to imagine that it was the machines that threw the market into chaos. We can turn off machines. We can regulate the hedge funds that use them. The problem might be solved if we just ended what Senator Ted Kaufman of Delware called the wild west trading environment in equities.
Unfortunately, there’s no evidence to suggest that high-frequency traders caused the crash. It appears that many pulled out of the markets during the Flash Crash, perhaps exacerbating the crash by withdrawing the liquidity they ordinarily provide. But the Flash Crash was well underway, and may have even been worse if the high-frequency traders had decided to keep trading the market down.
What’s clear is that replacing specialists on the floor with high-frequency traders and electronic trading was not as costless as advertised. Congress, prosecutors and the SEC spent decades fighting to liberate investors from what the lawmakers and regulators looked at as an archaic system of floor specialists. But with those specialists now largely gone, there were few checks in place when the market began misbehaving on May 6.
This should not come as a surprise. If the specialist system were truly as inefficient as regulators believed, we would expect that ruthlessly greedy brokerages would have done away with it without help from regulation. It appears now as if regulators were simply trading away one kind of inefficiency—self-dealing by specialists and slowly executed trades—for another—markets plagued by fears of sudden bouts of chaos.
“In other words, we have traded cheaper up-front costs for unknown back-end ones. That is exactly what is spooking the same investors the SEC vowed to protect in 2005,”Dennis Berman of the Wall Street Journal has written.
It’s enough to make me worry about what might happen when the SEC puts forth another round of regulatory proposals to solve the problems created by its last round.