wall street stocks investing flash crash
AP
By Brian Korn and Bryan Y.M. Tham

Three years ago, on May 6, 2010, U.S. capital markets experienced the "flash crash," when the Dow Jones Industrial Average suffered a stunning 1,000-point loss (9 percent) in five minutes, followed by an equally dramatic recovery. It could happen again.

Moments before the 2010 flash crash, individual stocks were trading at a greater than 90 percent discount to the price. Accenture PLC, for example, was quoted at $39 just prior to the flash crash, then had trades clear at $32.62, then $5.34, $4.04 and $1.84 before recovering to close at $41.09. The point decline in the Dow within a single day was the largest since the Dow debuted in 1896.

Despite the attention received from various news groups, economists, and the Securities and Exchange Commission, which published its findings jointly with the Commodities Futures Trading Commission in a study on Sept. 30, 2010, the specific cause of the flash crash remains in dispute. It's bad enough that the flash crash occurred. Worse though, is that the corrective measures have focused on mitigating the effects of the crash, not the cause.

Market crashes and government attempts to prevent future ones, are nothing new. The 1630s Tulip Mania crash at the end of the Dutch golden age led to government efforts to mediate contracts of affected merchants and hostility toward speculators. The U.S. Panic of 1873 resulted in national governments' embrace of protectionist policies and a shift away from the global silver standard. An investigation into the causes of the Wall Street Crash of 1929 led the Pecora Commission to recommend legislative initiatives which led to the modern securities laws.

Still, the 2010 flash crash exemplifies the risk created by a new and accelerating trend: the market's shift towards and reliance on automated computer systems in trading; and accordingly, a new class of risk to the markets -- the computer-based trading malfunction.

Since this flash crash, other computer-based trading malfunctions, or "glitches," have transpired, highlighting in each case other at-risk areas in the global trading system. On Aug. 1, 2012, Knight Capital suffered a technical glitch in its algorithmic trading systems, causing more than 140 stocks to be misquoted, eventually costing the firm more than $440 million and forcing it to raise significant capital. On April 25, 2013, a computer glitch in the Chicago Board Options Exchange shut down the exchange for half a day, preventing options trading on two of the U.S. stock market's most closely-watched indexes.

Similarly, concerns persist that markets remain vulnerable to the rapid dissemination of disinformation, such as cyber-terrorism initiatives aimed at general disruption. One of these was a false report on April 23, 2013, from a hacked Associated Press Twitter account, that the White House had suffered two explosions and that President Obama had been injured. This report resulted in sharp decreases in the Dow and the Standard & Poor's 500 Index; they rebounded after the AP revealed it had been hacked.

Each incident has prompted careful review and additional changes to regulatory and procedural safeguards by capital markets regulators, including, the SEC, the CFTC and the Financial Industry Regulatory Authority. These changes are largely designed to mitigate the potential risk of volatility or damage caused to the markets.

Regulatory changes generally fall into three categories: circuit breaker modernization, erroneous trade breaking rules, and new rules to strengthen minimum quoting standards. Here's how they each respond to a flash crash:

Circuit breaker modernization. On May 31, 2012, the SEC approved a "limit up-limit down" mechanism that prevents trades in individual exchange-listed stocks from occurring outside of a specified price band, to replace the single-stock circuit breaker pilot program, which was developed and implemented in response to the flash crash. This mechanism is designed to prevent trades in individual securities from occurring outside of specified price bands (percentage levels above and below a security's average reference price over a preceding five-minute period). It also implements rules that affect the treatment of such things as market and stop orders; specialist and market maker quoting obligations; declaration of trading halts by exchanges; and obvious or catastrophic errors.

In addition, the SEC approved market-wide circuit breakers that, when triggered, halt trading in all exchange-listed securities throughout the U.S. markets. Recently, the SEC approved modifications to these circuit breakers, including, among other things, replacing the DJIA with the S&P 500 as the determining index for circuit breaking. This would reduce the threshold of decline from to 7 percent from 10 percent, using change from the previous day's close instead of the last month of quarter average for decline calculations; reduce halt time to 15 minutes (instead of 30, 60 or 120 minutes); and reduce the triggering time for trading halt time periods from six to two minutes.

Erroneous trade breaking rules. Although contemplated prior to the flash crash, the SEC approved the Clearly Erroneous Pilot Program, which identified new rules following the flash crash outlining when an erroneous trade would be broken. These erroneous trade rules, which clarified when–and at what price–completed trades will be reversed, or "broken," by the exchanges and FINRA, were designed to foster a sense of certainty to reduce the likelihood of market panic and capital flight when computer glitches occur.

The lack of consistent standards for breaking trades prior to the Clearly Erroneous Pilot Program contributed to uncertainty of application. Clearly erroneous execution rules varied from exchange to exchange, with some breaking trades only if the price exceeded an objective threshold based on the preceding market price, and others relying more heavily on the subjective judgment of exchange officials. On May 6, 2010, the markets, using a process that was not transparent to market participants, only broke trades that were more than 60 percent away from the reference price.

New rules to strengthen minimum quoting standards. Immediately following the flash crash, the SEC implemented new rules for the exchanges and FINRA designed to strengthen minimum quoting standards and prohibiting certain practices, including "stub quoting" -- an offer to buy or sell a stock at a price so far away from the prevailing market that it is not intended to be executed -- requiring market makers in exchange-listed equities to maintain continuous two-sided quotations during regular market hours that are within a certain percentage band of the national best bid and offer.

In addition, the SEC required FINRA and the exchanges to develop, implement and maintain a consolidated audit trail system, which collects and accurately identifies every order, cancellation, modification and trade execution for all exchange-listed equities and equity options. This audit trail requirement is the result of speculation that the flash crash began as the result of a "fat finger" keypunch error by a broker-dealer employee, which, despite the appeal of its ease of explanation, has never been substantiated. The audit trails allow for increased measurable data available to regulators for investigations of illegal activities, and for timely forensic investigations and diligence of broad-based market events.

Despite all these efforts, not much has changed. The rapid pace in developing and implementing these protective mechanisms and others will increase the market's awareness and ability to react to glitch-based crashes. But at best, they will limit the effect of a flash crash -- not prevent it.

The precise cause of the flash crash remains unclear. Therefore, the markets are still hostage to episodic technological outages that cannot be predicted or understood. The most recently was the startling half-day outage at the Chicago Board Options Exchange that shut down trading in the S&P 500, the most traded options product, and the S&P Volatility Index.

What's ahead? Clearly more proposed rules and amendments to existing ones by the SEC. As cyber-terrorism becomes a greater concern, we can also expect government initiatives to address it. For example, in October 2011, the SEC's Division of Corporation Finance issued a directive to companies to disclose particular risks related to cyber-terrorism and hacking attacks. The market remains susceptible to "non-market" hacking, such as the AP Twitter incident. And none of the regulatory initiatives are designed to protect offending firms from the financial fallout when their systems go awry.


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23 Comments

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betty_brock

If you've had money stolen out of your paycheck for years. (Yes, what your employer pays IsALSO YOUR MONEY.) Thank a Dumbercrap.

August 12 2013 at 7:46 PM Report abuse -1 rate up rate down Reply
1 reply to betty_brock's comment
betty_brock

In the form of Social Security, that is.

August 12 2013 at 7:57 PM Report abuse -2 rate up rate down Reply
Nekima

The Scam market is just that...a scam run by people with a common interest to sway the stocks for profit/loss. If the government wasnt getting a cut n the form of "income tax" this would all go away. Just crooks watching over crooks. Welcome to the new USA>>

August 12 2013 at 5:26 PM Report abuse +3 rate up rate down Reply
sakreyer

Wall Street / "The Market" is NOT necessarily indicative of the economy on Main Street USA nor the average U.S. taxpaying worker. Too much of what has been touted as "recovery" has been synthesized by government trying to keep the poor economic decision making in check.

August 12 2013 at 12:30 PM Report abuse +6 rate up rate down Reply
1 reply to sakreyer's comment
theycallmeroy3

You're never going to get E-Harmony to equal E-Market. When that principle is understood, investing because easy. Algorithm or not.

August 12 2013 at 1:07 PM Report abuse rate up rate down Reply
1 reply to theycallmeroy3's comment
theycallmeroy3

becomes.

August 12 2013 at 1:08 PM Report abuse rate up rate down
tmoschetti

I believe "could have" is putting it mildly!
http://www.moneynews.com/MKTNews/Massive-wealth-destruction-economy/2013/06/20/id/511043/?promo_code=13E5C-1&utm_source=taboola

August 12 2013 at 12:20 PM Report abuse rate up rate down Reply
stock market

Just waiting for Obummer to bail out Detroit....then head to CA to honor all of his backers. I think Oakland will be next to need a bailout. That would make 4 or 5 cities bankrupt? Then there is Bell, CA where all of the city employees took out huge amounts of tax money for their own benefits....all these cities are run by democrats. Los Angeles has had the same city council members for a hundred years....democrats. Just look to the cities run by democrats and you can visualize what the rest of the USA will look like with all democrats in control.

August 12 2013 at 10:32 AM Report abuse -2 rate up rate down Reply
3 replies to stock market's comment
WILLS

The economics of the U.S. are slowly improving, but there always will be market corrections. Having moves in the 200-300 range are becoming normal as the present market is reactionary - the read information and digest later. A daily swing as described always remains a posibility, but so is being it by lightning on a sunny day.

August 12 2013 at 9:56 AM Report abuse +1 rate up rate down Reply
1 reply to WILLS's comment
theycallmeroy3

Fair summary. And did it keep you from not investing? Bet not.

August 12 2013 at 1:10 PM Report abuse rate up rate down Reply
michaelnel4449

It will happen again, you can bet the top 1% are planning their next sell off while many of us sit back and keep playing their game. Investing our money in their system does little for us and makes them wealthy because they plan and call the shots of when it goes up and down. Haven't figured it out yet, shame on you. You've had your chance to learn from these crooks....Until we force term limits on all of Congress, these corrupt games will continue.

August 12 2013 at 7:52 AM Report abuse rate up rate down Reply
1 reply to michaelnel4449's comment
theycallmeroy3

I like cynicism, except when it becomes hyper- cynicism. Then perception is distorted. You would not enjoy working on W-street. Be thankful.

August 12 2013 at 1:18 PM Report abuse rate up rate down Reply
mrspelosi

k4jlp
Hey Burhead,
I'm not on welfare like you Repukes think everyone is, I WORK for a living and pay Federal, State and Local taxes....put that in your martini and drink....

___________________________________

Oh my K4jlp I knew you were a liberal by your low class uneducated comment darling. It is such a shame that you had to show everyone here that you lack character and have no class. How unfortunate for you dear.

August 12 2013 at 12:08 AM Report abuse +1 rate up rate down Reply
1 reply to mrspelosi's comment
k4jlp

And I suppose since your using Nancy's name on AOL, we are to believe your educated and high class? Hardly.

August 12 2013 at 7:57 AM Report abuse -1 rate up rate down Reply
2 replies to k4jlp's comment
mrspelosi

Who is Nancy, dear? I know I am not educated and high class, something that you and I have in common doll. You appear to be quite bitter and hostile. Oh that's right you are a liberal. We liberals are a mean spirited group of people. Perhaps you should enroll in some anger management classes. It would do you some good dearest.

August 12 2013 at 2:10 PM Report abuse +1 rate up rate down
betty_brock

Are you kidding? Pelosi is smarter than ever.

August 12 2013 at 7:44 PM Report abuse -2 rate up rate down
Mr. ROC

Our current stock market and trading is nothing more than imaginary numbers, now held in a computer program. The imaginary value, is just that, Stocks, the paper kind held in "your" safety deposit box, will be good for some expensive toilet paper or something for your bird cage. The true dividend return will be paid by companies that produce a profit and return an honest return on your investment. Now, big managers move their imaginary stocks around from a computer in their offices. ALL imaginary, that can go away, with one big power outage, and the working people and the good companies will be left to do a good job as always.

August 11 2013 at 8:06 PM Report abuse +3 rate up rate down Reply
gmsexton

people are stupid if they think the next "crash" can be mitigated or controlled in any way shape or form.. by controls put in place by regulators. bottom line is the system is a joke and there are ways to by-pass it. with instant access and instant trades it will be like trying to stick your finger in the hoover dam to stop it from bursting... the market will run it's natural course... there is no preventing that.... the question is the speed at which it accomplishes this....

August 11 2013 at 11:13 AM Report abuse -3 rate up rate down Reply