Or, it appears, some thing.
As Mary Schapiro, the chairwoman of the Securities and Exchange Commission, said in Congressional testimony, “Automated trading systems will follow their coded logic regardless of outcome, while human involvement likely would have prevented these orders from executing at absurd prices.”
The computers that now dominate trading are amazing. Their speed of trading is measured in milliseconds. They can post and withdraw an order faster than you can read this word. If a fast computer is on the other side, then a trade can be made before any person could even notice a trade was possible.
That trade can then cause other traders’ computers to determine that momentum has shifted, and trigger huge orders to sell at the market price. The orders can also cause some brokerage firms to back away from making markets, which they do by posting a “stub quote,” such as a bid of 1 cent for a stock.
As the regulators try to work their way out of this, there are several things to keep in mind:
1. Markets are utilities for investors. We used to think that utilities are natural monopolies, which should be regulated rather than competed with. Changing that view, and allowing lots of new markets that could compete with one another on the basis of cost and speed, required much better regulation, but it did not happen.
2. One of the most important functions of markets is price discovery. For most major stocks in the United States, that role used to be performed by the New York Stock Exchange, which, despite a lot of automation, remained under the dominance of actual people. An important goal of the new regulation must be to assure price discovery functions well.
3. Don’t blame the investors. There is apparently no evidence of a “fat finger” trader who ordered a sale of billions of shares, when he meant millions. But even if there were, the systems should have prevented chaos. They did not.
4. To have a functioning market, someone must provide liquidity. Maybe we need to go back to paying people and brokerage firms to do that.
In the old days — whether they were good or bad depends on your perspective — nothing like the May 6 follies could have happened to a stock listed on the New York Stock Exchange. Confronted with a large order imbalance, the Big Board halted trading and tried to sort it out. That might not prevent a stock from plunging, of course. But the delay gave time for cooler heads to leap in if they wished to do so.
In those days, the exchange had a monopoly on trading in stocks it listed. So it could delay without costing it any business.
Also in those days, commission costs were far higher than they are now. Big brokerage firms made markets in stocks for institutional investors, and charged them for it through commissions and, if the order was large or hard to place, through price discounts.
An institution that wanted to unload a large block of stock would call one of a handful of brokerage firms. If it wanted to get out fast, it knew that Goldman Sachs or Salomon Brothers or Morgan Stanley would agree to buy it without lining up customers to take the stock.
How big a discount the broker demanded would depend both on its assessment of the market and on the institution’s reputation. If an institution was known for sandbagging brokers, perhaps by selling on news that was not yet public, or by selling blocks simultaneously to several brokers, it would find that subsequent sales were much harder to pull off.
Now we have competition between exchanges and computers with programs aimed at allowing an institution to parcel out stock in small blocks, so no one knows it is unloading. Liquidity is largely provided by so-called high-frequency traders, who have their own superfast computers and models that are supposed to allow them to get in and out rapidly, making a small profit on almost every trade.
Costs of trading have collapsed, and volume has soared. Ms. Schapiro pointed out that the 1987 stock market crash produced trading of 600 million shares a day — a figure that seemed incredible at the time. On May 6, the number was 10.3 billion, much of it from those high-frequency traders who had no desire to own — or short — stock for any length of time.
Here is what appears to have happened on May 6.
First, prices fell for real reasons. But as the selling became worse, buyers became scarce. The Big Board started to invoke what it calls “liquidity replenishment points,” or L.R.P.’s. Those are not trading halts, as in the old days. The exchange could never hope to get away with them these days. But they are pauses, usually for a few seconds, intended to “facilitate more accurate price discovery and prevent the market from a sudden and significant move,” as Larry Leibowitz, the exchange’s chief operating officer, testified.
Such pauses, he said, “are analogous to taking the controls of a plane off auto-pilot during turbulence.”