From the June 01, 2010 issue of Futures Magazine • Subscribe!

Exchanges investigate stock market plunge

In the days immediately following the May 6 mysterious market plunge, there were pledges from exchanges and regulators to get to the bottom of what happened, but as of press time, there have been very few details.

We know that equity markets, already in the midst of a long overdue downward correction, were having a bad day, likely in reaction to weakness coming out of Europe over negotiations of a Greek bailout. Then in a 15-minute period in the afternoon, selling went into hyper drive, taking the Dow from down 300 points to down nearly 1,000 before rebounding back to close down about 350. Perhaps more disturbing was odd price action in certain issues. For example, Exelon and Accenture, both approximately $30 billion companies, fell to a penny per share.

One possible factor was the use by NYSE Euronext of mini circuit breakers or liquidity replenishment points (LRPs). These are not the standard circuit breakers that were put in by the Securities and Exchange Commission (SEC) following the 1987 Black Monday crash -- that would have required a 10% downward move in the Dow Jones. LRPs are mini circuit breakers that the NYSE applies to individual equities during unusually volatile markets. The NYSE turns off its auto execution function and all orders for a stock in LRP mode are directed to the Designated Market Maker (DMM) who has an obligation to make a market.

According to an NYSE spokesman, on an average day there will be about 100 instances of LRPs, but on May 6 there were more than 1,000.

LRPs are unique to the NYSE, and when an equity is in LRP mode, other exchanges can trade away from the NYSE regardless of whether it has a better price. Orders bypassing the NYSE and going to less liquid venues could explain some of the dramatic prices seen on May 6.

The NYSE spokesman said NYSE did not bust any trades on May 6 and did not experience the wild prices that other venues saw.

On May 7, the SEC and CFTC announced the formation of a joint committee that will address emerging regulatory issues. The first item on the agenda is a review of May 6 market events with a focus on market structure issues that may have contributed to the volatility and “disparate trading conventions and rules across various markets.”

The day prior, SEC Chairman Mary Schapiro met with the six largest U.S. stock exchanges and stated, “The parties agreed on a structural framework, to be refined over the next day, for strengthening circuit breakers and handling erroneous trades.”

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