If exchanges are clearly so interconnected, why did no one see this flash crash as a potential risk? What is everyone doing with their big, fat, inflated heads in these organisations whose raison d’être, BTW, is to avoid this merde? Maybe that one comedian was right, everything worked better when martinis at lunch were tax deductible. Or do we just do not have enough cops working this beat.
We live in vulnerable times. I would really like to believe that someone is looking out for me. But I am afraid I don’t and there isn’t. I am not a cynic but this preliminary report is absurd and full of gobbledegook. This flash crash is not the most important thing that has happened lately. However, it is just too freakin' scary that they haven’t come out and admitted that this is something they overlooked—rather than some extraordinary event that could not possibly have been anticipated because after all, this is Wall Street and everything is complex and complicated.
What I really want to know is that some junior staffer wrote a memo years ago raising the issue of interconnected investment vehicles, traded across dozens of exchanges, creating the potential risk of a liquidity crunch...deja vu all over again…….and this memo was dismissed as untimely or irrelevant. At least if one little person saw this risk I would feel as if the universe still functioned properly.
Here are what I think are the primary issues raised in the report.
ETF’s
“…ETFs as a class were affected more than any other category of securities.” (in the flash crash)
Exchange traded funds (ETF) trade like stocks but function like mutual funds in that they can represent several different equities. ETF’s track the S & P 500 stocks and they often trade in large blocks. This means that when they lose value the underlying stocks are losing value. This means when traders see the S & P losing value they may want to sell in to that decline. The trader may have instructions to do this or they may want to cut their losses by selling before stocks decline further. Regardless of why, the circuit breakers need to kick in at this point in order to stop the bleeding. Those circuit breakers need to be across the board. Maybe we have found the achilles heel of demutualisation. Competitors do not like to co-operate. Believe me I know, I am the youngest of 4 girls.
Self-Help
The report discusses the affect on liquidity from the policy of ‘self-help’. For some stocks, exchanges are required to route orders to specific dominant exchanges. Which exchange is dominant will depend on the particular stock involved in the order. Declaring self-help means an exchange can re-route an order with impunity when the primary exchange does not respond to an incoming order within one second. It is these arrangements that provide some semblance of order in this new age of demutualised and electronic exchanges. Orders can go far and wide to be filled where they used to just go to the AMEX, NYSE or the PHLX.
Basically, what distinguishes stock exchanges from over-the-counter market is this kind of arrangement. Agreements regarding the primary market maker in stocks-predominately the NYSE for the S & P 500 stocks-means that the bid-ask can be managed in a reasonable, central way in order to avoid spreads that are unreasonable, unknown or worse, vastly disparate between exchanges.
SO, when the NYSE goes slow because of a sudden drop in prices, response time to incoming orders will be longer than one second. If an order is required by agreement to go to the NYSE first, self-help releases incoming orders from that obligation. The order is then re-routed to another exchange. This contributes to less liquidity on the NYSE for that period of time. This may be what happened on May 6th.
Futures market
”…there were many more sell orders than there were buy orders” An actual quote from a report issued by two regulatory agencies.
The Chicago Mercantile Exchange (CME) employs something called stop logic functionality. This facility pauses trading in certain futures when the last transaction price would trigger stop loss orders which, if executed, would result in precipitous declines in prices. Stop loss orders sit on the books and are used by investors big and small in order to indicate the bottom price where a stock must be sold in order to prevent further loss for the investor. It is not particularly sophisticated but functions as a way to stop the loss of value.
Simply put, you buy a stock or future at $45 per share and hold it in your portfolio. You have the broker enter a stop-loss order at $20 per share. God forbid the stock drops that low but when it does you sell your shares at $20 rather than at $10 or pennies per share.
Stub quotes
I don’t know a lot about this but will educate myself and return to the topic but I suspect this is a non-issue. These quotes are bottom quotes that are not anticipated to reflect the actual market. They came into play because the price drops were so fast.
The real issue is that in the ‘olden days’ NYSE specialists existed to provide liquidity and order. That was their professional obligation and they were seriously good at it. When orders can be re-routed all over the electronic universe who is managing the bid ask spread so that investors have consistency, transparency and predictability??? There has got to be someone in charge-an exchange that is the facilitator of last resort. Why are we still learning this lesson?
I increasingly feel as if the inmates have been running the asylum. Here is a quote from the report followed by my translation:
“CFTC staff is considering a proposed rulemaking with respect to exchange co-location and proximity hosting services. The purpose of the proposed rule would be to ensure that all otherwise qualified and eligible market participants that seek co-location or proximity hosting services offered by future exchanges have equal access to such services without barriers that exclude access, or that bar otherwise qualified third-party vendors from providing co-location and/or proximity hosting services. Another purpose of the proposal would be to ensure that futures exchanges that offer co-location or proximity hosting services disclose publicly
CFTC Staff will also be considering possible rules to enhance the CFTC’s surveillance capabilities. These measures include automation of the statement of reporting traders in the larger trader reporting system and obtaining account ownership and control information in the exchange trade registers”
June’s translation:
“Uh, fellas, the good times are ova. We can no longer make country club membership exclusive. Things are gonna be transparent. Playing in this game was so much more fun when it was limited to a few who reap all the fees and set all the rules. Dammit! Now we gotta disclose things and allow everyone to play.
Also guys, no more secret trading through a numbered account, we hafta know who ya are and what ya did and we’re gonna get the Geeks to write a program to help us do it.”
You get the idea. I could do this for all 151 pages of the report. They are proposing lots of joint studies one which will “…examine linkages between correlated assets in the equities (single stocks, mutual funds, and ETFs), options and futures markets.” They don’t know this stuff already? I mean with all the B’schools in NYC and D.C., you’re telling me some undergraduate hasn’t done a project or paper on this because that is the level we are talking about--baby stuff guys. Knowing how all your fancy products function together is your J-O-B.
This is how the report should have read:
“Dear American Investor and legislator,
We have been having so much fun making money over the last 20 years that we couldn’t really have cared less to understand how things work or what kind of markets we were creating. Sure we had a few scares over the years but we survived, passed a few rules, shifted blame. We have been exceedingly occupied with fighting against disruptive interference by busybody regulation year after year all with the sole purpose of bringing you the wealth that you now enjoy. We just learned last week how to even spell transparency.
Either way, we’ve been busy and now we are now ready to focus on this problem. But remember it is very, very complex and complicated. It will take years and many, many meetings in Boca or at the Greenbrier to make any real progress.
Please be patient and continue to love Wall Street because it has made this country what we are today.
(Air kiss)
Your friends in high places,
The Securities Regulating Elite”
Full stop
www.sec.gov
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