May 19, 2010
Speed Kills

Nearly two weeks since one of the worst, and quickest, meltdowns in Wall Street history and the regulators are still pouring over the data.  Armed with ancient technologies called computers and the internet, the slow moving SEC is making the case that market information must become standardized and fully automated, even if this throws a wrench into the high flying maneuvers of today’s speculators:

“It is important to emphasize that the review of the events of May 6 is in its preliminary stages and is ongoing…Although trading now occurs in microseconds, the framework and processes for creating, formatting, and collecting data across various types of market participants, products and trading venues is neither standardized nor fully automated…”
Preliminary Findings Regarding the Market Events of May 6, 2010 CFTC & SEC PDF

Even as the investigation into the ‘flash crash’ continues the CFTC and SEC have postulated the following: “This extreme volatility in the markets suggests the occurrence of a temporary breakdown in the supply of liquidity across the markets. “ Rather than simply warn individual investors about the risks associated with market orders and/or state the obvious fact that all stocks cannot be 100% liquid 100% of the time, the SEC has conjured up the following:

“Under the proposed rules, which are subject to Commission approval following the completion of the comment period, trading in a stock would pause across U.S. equity markets for a five-minute period in the event that the stock experiences a 10 percent change in price over the preceding five minutes. The pause 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. Initially, these new rules would be in effect on a pilot basis through Dec. 10, 2010.”
Stock-by-Stock Circuit Breaker Rule Proposals SEC

If you take the added bolds at face value the SEC is claiming that a ‘pause’ in a crashing stock would attract new trading interest and/or that after such a pause trading would resume in an ‘orderly’ fashion.  Isn’t it also plausible that as individual stocks sell off (perhaps for completely legitimate reasons) an otherwise normal trading day could turn into chaos as individual trading halts and resumptions undermine investor confidence?

The SEC also noted that as it tests out its new circuit breakers it will look at the ‘risks of market orders’ and ‘consider steps to deter or prohibit the use by market makers of "stub" quotes’. It goes without saying that the SEC is considering prohibiting ‘stub’ quotes is the height of hypocrisy. After all, if it obvious to the SEC that a quick 10% decline in an individual stock is unreasonable why allow
those parties supposedly charged with making markets to place useless bids that are well below the -10% threshold?

Roads without any speed limits = crashes more deadly

If regulators really want to stop another May 6 from occurring they should start with the premise that speed can kill.  To be sure, in some cases increases in market trading, much like an increase in the money supply, are simply a sign of an unsustainable increase in investor speculation that can presage a period of spectacular volatility (when the liquidity, like the money supply, dries up).  Thus, the lesson for regulators may not be to limit the damage that occurs when market liquidity/trading volume breaks down, but to try and make the buy/sell convictions of investors more reliable*.

A simple but potentially effective platform on this front would be to give individual companies/shareholders the option of having lock-up periods on their shares. The immediate result of such an action would be that market thinking would be geared to that of weeks or months rather than hours, seconds, milliseconds, or microseconds. Imagine a marketplace where hedge funds, ETFs, computers, and individual investors can only purchase shares in a company if they plan on holding those shares for a set period of time...I wonder if anyone can. 

Incidentally, any regulatory effort that tries to limit market activity is unlikely to come to pass as the exchanges, traders, and Wall Street would be against it. Nevertheless, what does the average investor (whose funds are oftentimes being quickly thrown around by managers) and the companies that do not care if their shares trade every second think about enacting lock-up periods?....

In short, *something tells me that anyone/thing that is vying to trade a stock for a few minutes or seconds here and there is not providing the type of liquidity that is reliable on days like May 6. Despite the SEC’s bias, greater trading volume alone does not a healthy market make.




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