Sent: 14-09-2010 12:10:35
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The Flash Crash Report
The SEC's "flash crash" report due in the next few days might highlight just how elitist markets are becoming and why retail investors could become even more alienated from them.
The flash crash was the brief but scary plunge in US stock prices that occurred on the afternoon of 6 May 2010. The Dow Jones industrial average had been weakening but suddenly plummeted 600 points in a few minutes. Within another 15 minutes, it had recouped most of the fall.
While there has been considerable discussion about the source of the collapse, ensuing panic and need to cancel trades, the Securities and Exchange Commission has yet to report definitively on the surrounding causes. The delay, evidence that the chief market regulator itself does not fully understand what happened, has itself unnerved US markets.
Interest in the report is high. The market fall came at a critical time after the exit of large numbers of retail investors and just as some hoped confidence was being rebuilt in market and economic conditions.
An understanding of what happened might be needed before confidence can be restored sufficiently to bring those investors back. According to statistics from the Investment Company Institute, mutual funds investing primarily in US stocks have faced continuing withdrawals now totalling $70 billion since the beginning of 2009. It is hard to see sustained positive returns against such a backdrop.
Traders are also waiting to see what recommendations for reform might follow. The US financial system has already been subjected to much scrutiny culminating in the Dodd-Frank financial regulation legislation. The rules implementing the legislated reforms have yet to be written. The trading community is nervously awaiting further restrictions on its daily activities.
This is one reason US market volumes remain subdued. In August 2010, S&P 500 volumes were 40-50% lower than the levels in October 2008 when the market was falling and in March 2009 as the market was turning. In Australia, All Ordinaries volumes peaked in August 2009 and, a year later, were one third lower.
Despite the seemingly subdued pattern of recent trading, market volumes have changed radically in the past decade. The lower volume of trading this August was still 230% higher than in August 2003 in the USA and 110% higher in Australia.
Technology has underpinned a huge uplift in trading. Large volumes of orders can be placed with little human intervention. As the capacity of markets to accept orders grows, traders push the limits.
A proliferation of trading platforms has decentralised trading just as volumes have been growing. This is one potential source of systemic instability. On the day of the flash crash, orders that could not be executed on one exchange were electronically channelled in less than a second to other trading platforms not all of which were designed to handle the increased volumes.
Automated trading systems do what their programmers have instructed without any regard to the outcome. Since trading times are measured in milliseconds, there is no scope for the exercise of human judgement. Several S&P500 stocks fell to 1 cent a share during the flash crash. Human market makers would never have allowed such prices or anything even close to them to eventuate.
Regulators are putting speed bumps in place which slow or stop trading when large price fluctuations occur but these electronic interventions may simply trigger a diversion of trades to other, sometimes less liquid, platforms. They will only work if the fragmentation of the market permitted by technology is reversed.
Australian market structures are lagging behind those in the USA but are turning in much the same direction. The decision by the Australian government to eliminate the ASX monopoly on stock trading brings Australia closer systemically.
The ongoing role of technology will be a critical outcome of the flash crash investigation. Should providers of trading platforms accommodate the ever growing volumes that can come with automated systems or should there be overt attempts to slow trade execution to safeguard the system and ensure efficiency? Until now, in a world in which speed and volume have been deemed desirable in almost any commercial activity, contemplating this trade off would have been a hitherto heretical mindset change.
The report will also have to address the fairness of markets. There has been a revolution in the availability of fundamental information. News is transmitted around the world in seconds and almost anyone has access to it. At the same time, retail investors had been given access to trading platforms once regarded as the leading edge of the market. Much of this happened under the eye of regulators in the name of equality for all participants.
The flash crash highlighted that investors are no longer equal. The democratisation of markets has run its course. The markets seen by retail investors on their screens are a shrinking part of the overall picture.
Now, the rapid deployment of so-called dark pools, trading algorithms and the growth of tiers of execution platforms are once again establishing a cleavage between retail investors and others.
Retail investors could be justifiably fearful of getting caught in the crossfire between competing institutions whose machines have been instructed to trade without regard to the consequences. Many will be looking to the SEC to see what protections will now be offered.
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