Views on the integrity of global capital markets
22 February 2016

Did Investor Stop Orders or Liquidity Disincentives Cause Aug ’15 Flash Crash?

Posted In: Market Structure
NEW YORK - MARCH 3: The floor of the New York Stock Exchange is seen in this time-exposure photograph March 3, 2003 in New York City. In early afternoon trading the Dow was down slightly after disappointing economic news on incomes, consumer spending and manufacturing data. (Photo by Mario Tama/Getty Images

Until recently, stop orders were known principally as a defensive trading device mostly by people whose day jobs prevented them from tracking the markets full time and in real time. Their purpose was to limit potential trading losses or to lock in investment gains. But that was before 24 August 2015.

During the first 15 minutes of trading that day, more than 20% of S&P 500 companies and 40% of NASDAQ 100 companies traded at prices greater than 10% below their previous day’s closing prices, according to an SEC report. In the view of some, investors’ stop orders morphed from mere defensive devices to instruments threatening the entire market, as limit-up/limit-down mechanisms were triggered not only after the markets opened, but a number of times on many stocks quickly after attempts were made to restart trading. The stop orders contributed to the significant imbalances in buy and sell interest, and helped exacerbate disparities between share prices for exchange-traded products (ETPs) and the values of the securities underlying the ETP shares.

In a prepared statement, Dennis Dick, CFA, told the SEC’s Equity Market Structure Advisory Committee that the problems highlighted by the trading halts and stop orders were the symptoms, not the underlying problem. “[C]ircuit breakers and warning systems for stop or market orders are mere band-aids for potentially larger underlying market structural issues, including significant reductions in liquidity during periods of market stress,” Dick told the committee on 2 February. “One issue that CFA Institute has raised concerns about in the past is the rising levels of off-exchange trading and the effects it can have on displayed market liquidity.”

While the incompatibility of market systems’ procedures for resumption of trading are seen as making matters worse on 24 August, retail investors’ stop orders came in for significant blame, as quickly falling prices triggered many of these standing orders. The New York Stock Exchange responded by proposing a rule change to eliminate the ability of investors to leave such orders on the exchange, even though most such orders are held by broker-dealers.

Speaking as a member of the CFA Institute Capital Markets Policy Council, a group of practitioners who offer insight into capital markets issues, Dick said that while educating investors about the risks of stop and market orders was important, it was only stopgap in nature. More fundamental to the markets’ panic, he told the committee, are the disincentives for limit orders — seen as indicative of investor price expectations — created by over-the-counter (OTC) market makers and trade internalizers.

Dick, a prop trader and equity market structure analyst at Bright Trading, said the trading activities of these firms frustrate investors who submit limit orders, causing a variety of problems. First, is the minimal, 1/100th of a penny in price improvement afforded by these firms to retail investors. This doesn’t justify market makers stepping ahead of the national best bid or offer (NBBO) and executing those orders away from displayed markets, he said.

Brad Katsuyama, a member of the Equity Market Structure Advisory Committee and CEO and co-founder of IEX, said that an estimated 30% of all trades boasting of providing price improvement to retail investors were priced at just 1/100th of a cent above the NBBO. He asked if there should be a minimum price improvement requirement “before a market maker can step ahead of the NBBO?”

Dick also suggested that investors’ missed trading opportunities create unquantifiable costs and ultimately harm investor trust as they watch the market ignore their orders in favor of others with such minimal amounts of price improvement. Order flow that is routed to OTC market makers has no chance to interact with orders on the public markets.

“With hidden exchange volume accounting for 9.1% of total volume in the third quarter of 2015, many marketable orders could be missing out on the chance to receive significant price improvement if those orders were routed to the public exchange,” Dick told the committee.

Dick’s bold comments did not receive universal support. Committee member Jamil Nazarali, head of execution services at Citadel Securities, opened the Committee’s discussion by stating, “I disagree with almost everything Dennis just said.” Maureen O’Hara of Cornell University, likewise rejected Dick’s analysis, saying the results from Canada’s experiment with requiring meaningful price improvement weren’t “so great.” (See our related policy brief. Our research concluded that much of the failure was due to permitting broker-preferencing, a practice allowing brokers to take their clients’ orders to the top of the trading queue. An earlier experiment in Canada targeting broker internalization produced noticeable benefits to investors.)

Buy-side members of the committee, on the other hand, recognized the issues Dick raised and suggested that these practices are undermining the value of our trading markets. “We have an environment that doesn’t facilitate price discovery,” said Kevin Cronin, global head of trading at Invesco. “My concern is that retail investors’ interests are trumping the market’s price-discovery needs. Our obligation has to be about price discovery.”

In the end, Dick’s comments (co-panelist Christine Parlour, from the University of California, reported similar findings) refocused the committee’s attention away from the technical issues of stop orders and toward the more fundamental issue of trading market regulation and equity market structure. It was an issue that the SEC has heard many times from CFA Institute. That it was raised in this forum and seconded by other buy-side participants may give the view greater emphasis.

See related blog post, “Are “Lit” Trading Venues Too Toxic for Average Investors? Is HFT Flash Crash Culprit?”


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Image Credit: iStockphoto.com: EdStock

About the Author(s)
Jim Allen, CFA

Jim Allen, CFA, is head of Americas capital markets policy at CFA Institute. The capital markets group develops and promotes capital markets positions, policies, and standards.

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