Report detailing May 6 ‘market failure’ expected this week

By Dow Jones Newswires-Wall Street Journal
Posted Sep. 29, 2010 at 6:51 a.m.

As the Securities and Exchange Commission finalizes its report on the May 6 “flash crash,” it is being forced to confront the fallout of its own decisions — which Wall Street sought and cheered — that ushered in an era of fast trading dispersed across dozens of venues.

As recently as this spring, many were applauding the speed, lower costs and competitive nature of the U.S. stock market that largely grew out of a series of policy and technology changes over a decade. “Who could argue that competition was a bad thing . . . and that faster trades would be a bad thing?” asks Joseph Saluzzi, co-head of trading at broker Themis Trading.

But the flash crash, he says, shows there have been “huge, unintended consequences.”

A report by the SEC and the Commodity Futures Trading Commission on that day’s steep decline, which saw the Dow Jones Industrial Average collapse 700 points in minutes before rebounding, is expected as soon as this week. SEC Chairman Mary Schapiro has called the day’s events “clearly a market failure.”

Staff from both agencies, which provided an initial joint-account in May, continued Tuesday to negotiate how certain events would be described in the report, according to people briefed on the discussions.

One area of discussion, one person said, concerns the so-called “E-mini” futures contract, which mimics movements in the Standard & Poor’s 500 index and was a source of heavy trading that day when liquidity dried up. Part of the discussion concerns whether to disclose the number of contracts exchanged in the E-mini contract, which could show the size and impact of the trades.

The CFTC doesn’t want to name the company behind the trade, this person said. The Wall Street Journal and other news outlets have identified the firm as Waddell & Reed Financial Inc. Waddell has said it didn’t intend to “disrupt” the market.

“We expect the report will highlight any areas in which market structure played a role in the events of May 6,” Schapiro said in a statement this week. A spokesman for the CFTC didn’t respond to requests for comment. An SEC spokesman declined to comment on the report.

While the SEC has been pilloried in recent years for failures such as ignoring tips about Bernard Madoff’s Ponzi scheme, the agency had started to ask questions about the reliability of the stock market months before the flash crash.

In January, in a so-called concept release on stock-market structure, the agency noted the significant changes that have taken place in trading thanks both to regulatory developments and advances in technology.

The changes were largely designed to usher in increased competition and speed, both of which were seen lowering costs for investors. In the release, which sought public comment, the SEC raised questions about what downsides the changes had wrought for markets.

Before May 6, the vast majority who responded to the SEC’s concerns dismissed them.

We “think that our current equity-market structure generally works well,” wrote Joseph M. Velli, chief executive of brokerage firm BNY ConvergEx Group LLC, in comments filed in April. “Innovation and technological advances can fix many perceived problems without the need for additional regulation.”

Velli said this week through a spokesman that he “would support certain technical rule changes, like the single-stock circuit breakers, designed to iron out a few limited issues.”

Some Wall Street players say the changes appear to have left markets more vulnerable to rapid and unchecked swings than had been anticipated.

Among the changes: The SEC in 1998 adopted regulation ATS to allow for nonexchanges to execute trades electronically. That marked a precursor to today’s dark pools, private trading venues that have taken substantial trading volume away from the public exchanges. Schpiro has recently raised questions about the effect of dark pools on market stability and investors’ ability to size up prices.

In 2000, the SEC mandated stock pricing in pennies instead of 1 8 fractions, a move that was touted as a benefit to small investors but that also has reduced the per-trade profits and incentives for traders expected to bring stability as market makers.

In 2005, the SEC adopted Regulation NMS, aimed at opening up stock trading to greater competition and ending the duopoly of the New York Stock Exchange and Nasdaq Stock Market.

The 2010 concept release questions whether having numerous trading centers, compared with essentially two a decade ago, could have a damaging effect. It asked whether there should be minimum requirements on the duration of orders.

And one question that became especially relevant after the flash crash was whether high-speed traders who reliably supplied liquidity would do so in crisis. “Are their orders accurately characterized as phantom liquidity that disappears when most needed by long-term investors and other market participants?” the release asked.

Larry Leibowitz, chief operating officer of Big Board operator NYSE Euronext, says the SEC’s broad questioning of market structure is appropriate. “Regulations don’t exist in a static world. Regulations need to be tailored and tinkered.”

Others say that, despite the May 6 flash crash, the markets are largely functioning well. Plus, any new alterations could themselves have unintended consequences.

Dan Mathisson, head of electronic trading at Credit Suisse Group, before May 6 described the recent evolution of the stock market as “a complete success.” He largely stands by that assessment.

The flash crash “clearly revealed some problems,” Mathisson said in a recent interview. “But it does not throw away all the tremendous progress that the market has made.”

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