The May 6 "flash crash" left investors stunned and wondering about the security of the U.S. marketplace. Unlike in past crashes where investor trust was badly shaken as a result of large losses, the flash crash left investors doubting the very structure of the marketplace.
In the wake of such shattered trust, the Securities and Exchange Commission (SEC) is working to restore investor confidence by implementing a number of market structure changes. One of those, the single-stock circuit-breaker pilot, is set to expire soon and two new rules were recently introduced.
Following May 6, the SEC implemented single-stock circuit breakers on the stocks in the S&P 500 and the Russell 1000. The idea was to place a trading threshold on single stocks. The pilot program is set to expire on Dec. 10.
While most analysts feel the program has been at least mildly successful, Joseph Saluzzi, co-head of equity trading at Themis Trading, likens the program to a Band-Aid on a much larger problem. "They may help a little [in another flash crash], but they are not the magic bullet some have made them out to be. There are other issues in the market, such as linkages and fragmentation," he says.
One of the chief complaints about the circuit breakers is that they can be tripped too easily. A single erroneous print is enough to halt a stock. This has resulted in many calling for better parameters and has some, such as Peter Bottini, executive vice-president of trading at optionsXpress, warning of the new dangers they present. "As more people become involved and aware [of the circuit breakers], more gaming can become prevalent with people taking advantage of this by actively printing erroneous bids to halt a stock," he says.
So far the breakers only have been tested a few times. "The challenge is that we haven’t had an event to really put them through their paces. Unfortunately, the whole system has not been tested," says Paul Zubulake, senior analyst at Aite Group.
Recently the SEC introduced two further changes. The first was to ban naked access to the markets and the second was to ban stub quoting (see futuresmag.com/stub). Banning naked access was in the works before May 6, but has just now been released. When the rule goes into effect in January, broker-dealers will no longer be able to simply provide their clients with "naked" or "unfiltered" access to exchanges. Instead, they will be required to ensure that their clients are performing pre-trade risk management.
The real impact of the move is geared toward high-frequency traders. "The high-frequency firms are not going to want to have any slowdown in their systems as a result of this move. The question is, does the sponsor need to have real-time data or can it be drop-copy out of the high frequency trader system?" Bottini says.
Zubulake adds that this move mostly affects smaller trade shops; he expects most of the larger ones to simply become their own broker-dealer.
While Zubulake does not see the move as making a big improvement in the financial landscape, Saluzzi reminds that it is another step toward eliminating risk. "With naked access, you could have people entering the market from anywhere in the world with no price or quantity thresholds," he says. "[The ban on naked access] takes some risk out of the system as it eliminates the rogue trader who is not being price or quantity checked."
Ultimately, while these moves have been steps toward eliminating market risk, there are still much larger problems that exist. "Single stock circuit breakers and banning stub quotes are like putting a Band-Aid on an infected wound. You are not cleaning out the wound. It is still there, will continue to fester and will pop back up again," Saluzzi says. "Can you still have a flash crash tomorrow? The answer is yes."