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

Deconstructing the flash crash

The first regulatory changes following the May 6 “flash crash” were approved on June 10 by the SEC, instituting single stock circuit breakers on a trial basis through Dec. 10, 2010. The call for circuit breakers on individual stocks came after none of the market-wide circuit breakers were tripped on May 6.

Under the new regulation, trading in a stock that has dipped 10% in a five-minute period will be frozen for five minutes. According to the SEC press release, “The pause, which would apply to stocks in the S&P 500 index, would give the markets the opportunity to attract new trading interest in an affected stock, establish a reasonable market price, and resume trading in a fair and orderly fashion.”

Following the “flash crash,” the CFTC and SEC released their preliminary findings to the Joint Advisory Committee on Emerging Regulatory Issues on May 18. Since then, the committee has continued investigating the incident.

While there is hope that these circuit breakers would remove the possibility of another flash crash, there are still some areas that may need shoring up.

“Circuit breakers need to be circuit-wide for them to make sense. There needs to be uniform rules across all market places and coordination with the derivatives market,” says Paul Zubulake, senior analyst at Aite Group.

One practice that has received attention during the investigation is “stub-quoting.” According to the preliminary report, some markets allow market makers or exchange specialists to make placeholder bids and offers far away from the market price to technically meeting their obligation to create liquidity in the market. This means bids as low as a penny and offers thousands of dollars above market price are allowed.

The main idea is that while these market makers are expected to maintain their bids and offers near market levels, because of the speed of the electronic markets, there may be times when demand in either direction can outpace the market makers’ ability to fill orders.

On May 6, though, as liquidity evaporated, these stub quotes quickly became the only outlet. When a market order is seeking liquidity and the only liquidity available is a penny-priced stub quote, the market order will execute against the stub quote. As a result, we saw valuable stocks sold for as low as a penny before the exchanges busted the trades.

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