On May 6, 2010, the Dow plunged nearly 9.8% in 10 minutes, its biggest intraday point drop ever, according to the Wall Street Journal. After the midafternoon collapse, the Dow recovered to close only 3.2% below the prior day. Many individual equity securities and exchange traded funds (“ETFs”) suffered similar declines and reversals within a short period of time, falling 5% to 15% before recovering most, if not all, of their losses. According to an SEC report, published several months later, this “flash crash” was brought on by high-frequency trades executed by a single unnamed firm “against the backdrop of unusually high volatility and thinning liquidity.” As a result, regulators are now looking into regulations to safeguard against such events going forward.”
A large trade may be executed in several ways: (1) by engaging an intermediary, (2) by manually entering the order into the market, or (3) by executing trades via an automated execution algorithm. The third option of using sophisticated electronic trading platforms carries the promise of giving “high frequency” traders an advantage in the buying and selling of stocks. There is an inherent risk, however, of electronic errors ripping through markets and disrupting them. On May 6, this is precisely the risk that was realized when a large unnamed fundamental trader executed an automated execution algorithm programmed to feed orders into the June 2010 E-Mini market (a futures index of the S&P 500). The program was designed to hedge risk by targeting an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time. As a result of the already stressed market, the execution of this sell program resulted in the sale of 75,000 contracts within 20 minutes. The trade represented the largest net change in daily position of any trader in the E-Mini since the beginning of the year and as a result triggered a ripple effect through the markets.
The measures in place to prevent such drastic chain reactions in the markets failed. Originally adopted in October 1988, market-wide circuit breakers designed to trigger trading halts in response to large market declines have only been triggered once, in 1997. These circuit breakers were enacted in response to an almost identical intraday drop of 22.6% on Black Monday, October 19, 1987. According the Wall Street Journal, the chairman of the Securities and Exchange Commission at the time, David Ruder, told the Senate Agriculture Committee in early 1988, “I simply cannot give you assurances that we have fixed the system.” Unfortunately, the lack of a market-wide trading halt on May 6 has given new life the former chairman’s fear.
In a new effort to the fix the system the Securities and Exchange Commission announced on September 27, that the national securities exchanges and the Financial Industry Regulatory Authority (FINRA) are filing proposals to revise the existing market-wide circuit breakers. The proposals would revise the existing market-wide circuit breakers by:
- Reducing the market decline percentage thresholds necessary to trigger a circuit breaker from 10, 20, and 30 percent to 7, 13, and 20 percent from the prior day’s closing price.
- Shortening the duration of the resulting trading halts that do not close the market for the day from 30, 60, or 120 minutes to 15 minutes.
- Simplifying the structure of the circuit breakers so that rather than six there are only two relevant trigger time periods — those that occur before 3:25 p.m. and those that occur on or after 3:25 p.m.
- Using the broader S&P 500 Index as the pricing reference to measure a market decline, rather than the Dow Jones Industrial Average.
- Providing that the trigger thresholds are to be recalculated daily rather than quarterly.
In addition to more robust trade-halting regulations, the SEC has undertaken other initiatives to respond to the events of May 6, including (1) the approval of new rules clarifying how and when erroneous trades would be broken and (2) approving new rules to strengthen the minimum quoting standards for market makers and effectively prohibit “stub quotes” (very low bids and very high offers, essentially place holder quotes used by market makers when liquidity has been exhausted under the belief that such quotes would not be reached) in the U.S. equity markets. Although it has taken some time for the SEC to respond to the events of May 6 with some concrete changes, the resultant regulations are a marked improvement from the status quo ante. What remains to be seen, however, is whether they have any teeth.