Flash Crash Continues to Rattle Investors’ Faith in the Market

As we kick off the fourth quarter, the S&P 500is up a little over two percent in 2010, so these next three months are a make-or-break quarter. One reason I say that is because there are a couple of specific fourth-quarter events that will strongly influence where the market ends the year: the midterm election and the upcoming holiday shopping season.

While not specific to the fourth quarter, I would say that another major influence right now is investor confidence, which has been a serious problem going back to the “flash crash” on May 6.Looking at the volume, it’s clear that many individual investors have not returned to the market.

Mary L. Shapiro
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Mary L. Shapiro

I recently talked with SEC Chair Mary Schapiro to get her take on why so many individual investors appear reluctant to get back into the market and to find out what she is doing to inspire confidence once again.

The SEC has major challenges right now that impact all investors.

First, the agency still has to address what went wrong with the flash crash. We’ve seen more instances of sudden, sharp drops in stock price, including just last week when Progress Energy plummeted from $44.50 to $4.50 last Monday.

The SEC did issue a report last week saying that the flash crash was caused by computerized tradingin an unstable market, but that’s not really news to anybody, and there weren’t really any proposals to prevent it from happening again. The biggest problem is that there aren’t standard “circuit breakers” across all stock exchanges. Result: If shares are halted on the New York Stock Exchange, computers instantly forward the trade elsewhere, often to a marketplace with little volume. That lack of liquidity is why a stock can go from $44 to $4 faster than you can say “flash crash.”

That’s a flawed system, and I question whether we have sacrificed market integrity for the sake of speed.

Do we really need trades to be executed in microseconds?

I asked Mary Schapiro that question, and she agreed it is the central issue.

But she clearly doesn’t want to respond to the problems caused by speed with a series of policies born of, well, speed.

She’s totally aware of the law of unintended consequences, and she pointed out how hard it would be, from a policy standpoint, to “turn off the switch” that enables flash trading.

In addition, the SEC is stretched thin. It has 105 new rules to enforce from the Dodd-Frank financial reform legislation and 35,000 new institutions to cover because hedge funds will now fall under the agency’s purview. So, of course, the SEC'S budget and staff will grow commensurately, right? Nope. That's not in the cards these days in fiscally strapped D.C. That’s a travesty, because in many ways our capital markets depend on the confidence of individual investors like you. And if you’re not confident that the system’s rules are being enforced fairly, you’ll do the logical thing: You’ll sit on your investment checkbook until your confidence returns.

Mary Schapiro hasn’t been doing interviews since the flash crash in May, but she agreed to sit down with me, and I think it’s important for individual investors to know what’s going on in this area. This is an important story that doesn’t appear close to being resolved. I will keep you updated here in Investor Briefand on CNBC.