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Trading System May Have Dangerous Flaw

Why do stocks have a slight bid to them in the U.S.? Traders are saying that the busted trades are creating a bid on the Street. Think about it: all the guys who bought, say Accenture at $0.10 and sold it at, say, $30 (!) got busted. They now have to buy that stock back. That will put a bid in the market.

Fat fingered trade? Computer glitch? It's possible that one of these was the cause of yesterday's drop, but as traders stream into Wall Street, the worry is that this could have happened without a computer glitch or fat fingered trade.

Fragmented market liquidity, problems with market rules:

The NYSE has liquidity replenishment points (LRPs) which allows designated market makers on the NYSE floor to slow down trading when stocks trade outside of certain parameters.

That's what they did with P&G about 2:45pm ET yesterday; in the 90 seconds or so that trading was slowed at the NYSE, the stock went from $60 to $39 off the NYSE floor.

Here was a big part of the problem: Reg NMS, adopted in 2005, says all markets must route orders to the best price, and if your market is not automatically accessible, or slows down, people can trade through you with complete impunity.

That's what happened; once liquidity was removed from the NYSE floor, even for 90 seconds, trading went to markets where there were obviously thin or nonexistent bids.

When you send normal orders on the NYSE floor to thin markets, prices drop fast and computers automatically cancel bids. As prices drop further, more bids are cancelled.

The proponents of all-electronic trading argue that the NYSE was part of the problem; that there is no need to slow trading. Others argue for more uniform regulations — that everyone should follow the same rule and no one should be allowed to trade through. That certainly makes more sense and is likely where this will end up.

The argument that computers are not in control of the markets, that they are merely programmed by traders, does not hold a lot of water when a stock goes from $40 to $0.01 in a matter of seconds, as happened with Accenture.

In other words, there may be a flaw at the heart of the trading system, which is now routinely seeing 6 billion share trading days due to high frequency trading. Yesterday, the NYSE consolidated tape saw 10.7 billion shares changing hands.

What's the solution? In times of stress, it is not unreasonable to argue that we need to have circuit breakers and the rest of the market should not ignore the primary market maker. This may be the NYSE or the Nasdaq, whomever the primary market maker is. In this case, the NYSE floor stepped in and tried to create an orderly market. But the rest of the world chose to ignore them.

If there is some kind of circuit breaker, it should apply to everyone.

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Other Companies in the News:

Citigroup

AIG

Bank of America

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Questions? Comments? tradertalk@cnbc.com