Duct Tape and Circuit Breakers
For those of us who were around back in 1987 (the year I received my CFA charter, I might add, boastfully), the circumstances of the “flash crash” of 6 May 2010 were in some ways a modern equivalent to the events of 19 October 1987. Back in 1987, it was a slow, steady draining from the market that lasted all day. Every time one looked at what was happening in the market, it was worse, sometimes much worse, than the last time. The events of a year ago are similar, just at the much faster pace of today, where we receive news from around the world in near real time and trade execution is measured in nanoseconds.
Aside from the official report that an unnamed buy-side firm (aka Waddell & Reed) launched the cascade with a seemingly innocuous $4 billion short derivatives position to hedge its long position in the cash securities market, the real question that everyone continues to ask is what caused it? Put another way, what have we learned in the intervening 365 days?
First, we have learned that the circuit breakers deployed after the crash do a good job of halting sell-offs, but they don’t prevent them. As The New York Times chronicled last autumn in this story, there have been a series of mini flash crashes since May 2010. In most cases, the price of a company’s shares suddenly, and inexplicably, falls off a cliff before the circuit breakers kick in and halt the slide.
One could say that these circuit breakers have done their job. In much the same way that circuit breakers in a home’s fuse box does their job, they prevent a serious failure. But, like a fuse box, if those circuit breakers keep tripping, you begin to recognize that you have a more serious wiring problem that needs repair.
The question is what is that fundamental “wiring” failure in the market? On the technical side, it is evidently momentary mismatches between buying and selling interests. More fundamentally, however, it is a function of the current market structure discouraging liquidity providers from placing limit orders as they have in the past. And they don’t because other market participants, hidden with the benefit of different market rules, step in front of their orders at the last nanosecond, leaving the limit order unfilled. The only time those limit orders do get filled, however, is when they are on the wrong side of the market — sort of a “heads I win/tails you lose” situation.
Curing the Symptoms
To this end, the SEC has proposed — and CFA Institute has supported — introduction of a “trade-at” rule. This rule would prevent those last nanosecond step-ins by requiring market participants to post a bid or offer for a certain amount of time prior to trading at that price, forcing these orders to the lit market, if only for a brief period.
Again, though, this solution is a stop-gap measure designed to cure the symptoms without fixing the underlying cause. And the underlying cause, as my colleague Rhodri Preece pointed out earlier this year in his study of the MiFID structure in Europe is a market structure that treats entities effectively doing the same thing — in this case, providing a multilateral trading venue for investors — differently. The different rules benefit some market players while tying other, more transparent entities down. Consequently, opaque brokers’ internalized crossing networks continue to gain market at the expense of lit markets, be they traditional exchanges or electronic communication networks, or ECNs.
Even if the SEC decided to do something about these fundamental weaknesses, it is unlikely they could, given the likelihood that those with interests vested in the status quo would use their influence with Congress to prevent it. We’ve seen similar efforts in the past.
In the meantime, we just have to hope that the SEC’s stop-gap measures work as intended. Otherwise, another major market failure is just one failed circuit breaker away.
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