By Edward E. Kaufman Jr. and Carl M. Levin
New York Times
May 5, 2010
One year ago, the stock market took a brief and terrifying nose-dive. Almost a trillion dollars in wealth momentarily vanished. Shares in blue-chip companies were traded at absurdly low prices. High-frequency traders, who use computers to look for microscopic price differences in stocks on different exchanges and other trading venues, stopped trading, while others immediately sold whatever they bought, mainly to each other, in what has been called “hot potato” trading.
We haven’t had a repeat of last year’s “flash crash,” but algorithmic trading has caused mini-flash crashes since, and surveys suggest that most investors and analysts believe it’s only a matter of time before the Big One.
They’re right to be afraid. The top cop for our financial markets remains inexcusably blind to the activities of high-speed computer trading.
After the flash crash, the Securities and Exchange Commission moved quickly to apply a Band-Aid in the form of circuit breakers to limit daily price moves. Then it proposed a long-overdue consolidated audit trail, to plug the gaps in reporting requirements that prevent the efficient tracking and policing of orders and trades. It spent months painstakingly using antiquated methods to reconstruct and study the trading data during the flash crash. With the Commodity Futures Trading Commission, it convened a joint advisory committee, which presented an array of recommendations in February. And it continued to dither.
The consequences of inaction are dire. If the average investor comes to believe stocks are valued not on the basis of a company’s expected future earnings but on the machinations of computers trading against other computers for speed and advantage, our stock markets will have become a casino.
The explosion in computer-based trading has occurred over the past decade as the S.E.C. adopted rules that allowed dozens of new trading venues to compete for stock orders and accelerated the move toward high-frequency trading, which now accounts for 70 percent of daily stock-trading volume.
While competition has lowered trading costs and in some cases improved efficiency, the result has been a confusing amalgam of more than 50 electronic trading networks, some of which are designed to hide large block trades, and traditional exchanges, which are governed by outmoded regulations that do not require full transparency. High-frequency traders navigate this maze with ever more sophisticated technology — and armies of computer and math specialists — to find and exploit slight price variations.
Yes, both volume and volatility in the equity markets have been declining in recent months, but the centrality of high-frequency trading has not diminished. Moreover, high-frequency traders have gone beyond trading stocks to futures, options, bonds, currencies and other asset classes — and are making incursions in foreign markets. The next flash crash could be more pervasive than last year’s, as global asset markets become increasingly correlated through the convergence of computer-driven trading strategies.
Why hasn’t the S.E.C. acted? Defenders would say that Congressionally imposed deadlines for instituting the Dodd-Frank overhaul of financial regulations have overwhelmed the commission and forced it to put changes to the equity markets on the back burner.
But the paralysis at the S.E.C. runs much deeper. It’s been 20 years since Congress gave it the authority to require large-volume traders to make more detailed disclosures; 18 months since the commission’s chairman, Mary L. Schapiro, said it would use that authority; 13 months since the agency proposed a rule to do so; and three months since the advisory committee recommended proceeding with “urgency” on the audit trail.
Meanwhile, even Ms. Schapiro has publicly expressed worry that our markets no longer adequately perform their main functions: helping companies to raise capital to innovate and grow and helping long-term investors to contribute to the American economy while building a retirement nest egg. Mutual fund outflows continued unabated after the flash crash through the end of 2010, an indication that ordinary investors are fleeing the market.
In response, the S.E.C. should work with the C.F.T.C. to establish the audit trail, which would allow real-time monitoring of electronic trading; stop trading venues from catering unfairly to high-speed traders at the expense of regular investors; make high-frequency traders bear their fair share of the costs involved in heavy, instantaneous flow of electronic messages, which would discourage strategies to stuff the system with orders that are immediately canceled; and rethink rules that give too much priority to the rapid-fire orders that high-frequency traders rely upon.
More is at stake than the confidence of small investors. A survey by the consulting firm Grant Thornton shows that initial public offerings by small companies have declined over the past 15 years. The profits to be made in supporting small-cap stocks have dried up as Wall Street has focused obsessively on leverage and high-volume trading.
One promising idea being floated is an experimental market, with rules tailored to support the capitalization of the fastest-growing companies, many of them start-ups that are drivers of job creation.
America’s capital markets, once the envy of the world, have been transformed in the name of competition that was said to benefit investors. Instead, this has produced an almost lawless high-speed maze where prices can spiral out of control, spooking average investors and start-up entrepreneurs alike.
The flash crash should have sounded an alarm. Unfortunately, the regulators are still asleep.
