More manipulation of the markets by dark fibre and high frequency trading?

Aivars Lode

The Flash Crash, in Miniature
By GRAHAM BOWLEY
Published: November 8, 2010

Mark Mulhern, a Progress Energy executive, was told its flash crash was a mistake.

For no apparent reason, Progress’s share price had plunged almost 90 percent. In a matter of seconds, a company with 3.1 million customers and 11,000 employees had all but vanished on the nation’s stock market, and Progress executives had no idea why.

In the anxious hours that followed, the answers began to come clear: the harrowing plunge in the early afternoon of Sept. 27 had been a mini flash crash — a small-time version of the stock market’s wild day last spring.

Since the Dow Jones industrial average fell about 700 points then largely recovered on May 6, setting the financial world on edge, similar flash crashes have occurred with alarming frequency in more than a dozen individual stocks.

Citigroup, Core Molding, the Washington Post Company — all have soared, plunged, and often both, in wild, seemingly inexplicable trading. An exchange-traded fund, a popular investment that is basically an index fund that trades like stocks, has also been given the flash treatment, although that was attributed to a software error.

To some analysts, these mini flash crashes are a sign that another big one is possible, if not probable. Others say these abrupt reversals are simply the way modern, lightning-quick markets work, and that investors had better get used to it.

The crashes continue even as Washington regulators investigate the structure of modern markets and as a report traced the main trigger of May’s big crash to a poorly timed trade by a mutual fund in Kansas. Regulators have put in place circuit breakers to halt trading and reset prices in case stocks plunge. But some analysts fear that one day, these mechanisms could be overwhelmed.

And to corporate executives caught in the middle, it is all just plain hair-raising — and still puzzling.

That September afternoon, with fearful investors on the phone from New York, Mark F. Mulhern, Progress Energy’s chief financial officer, was told by the exchanges that it was all a mistake. A wayward keystroke by a trader somewhere had unleashed a powerful computer algorithm that had devoured Progress Energy’s stock in moments.

Progress Energy stock was trading at about $44.57 a share, and a dealer at an unidentified brokerage firm had entered a mistaken sell order into a computer that instantly drove the price to $4.57. Dozens of trades were declared void, and after a five-minute halt, normal trading resumed.

Mr. Mulhern says he still does not really know what caused the sell-off — and worries what mini flash crashes like this one are doing to investors’ confidence in the stock market.

“It is a little disconcerting when a trade like this could cause this kind of havoc,” he said. “It has got implications for the confidence in our markets. I don’t know what caused it, to tell the truth. The one hesitation all investors have about the market is the drift to so much electronic trading. It is so fast and real time, you have to wonder a little bit how these things happen, and can the regulatory procedures, the stop measures, can they really keep up with the technology?”

Robert F. Drennan Jr., the vice president for investor relations at Progress Energy, said he had reviewed the trading records and had noticed unusual trading activity in the run-up to the plunge. He said Progress Energy was not a heavily traded stock; it may go for several seconds without a trade. But before the price fell, “There was a big ramp-up in the trades, hundreds of trades a second,” he said.

Mr. Mulhern said he received calls from worried investors, including hedge funds: “When the hedge funds call up and start to complain, you know you have a problem.”

The fall set off circuit breakers the exchanges had put in place after May 6. The circuit breakers are intended to halt trading of a stock for five minutes if its price changes by 10 percent within a five-minute period, and thus to stop panic from spreading.

In the case of Progress Energy, the circuit breaker worked on the New York Exchange, Mr. Mulhern said, but trading happens so fast that before other exchanges could also halt trading, the company’s stock price continued to fall on the Nasdaq, all the way down to $4.57.

On Oct. 26, a surge in the shares of Aaron’s, the furniture and appliance retailer, also set off the new circuit breaker. Gilbert L. Danielson, chief financial officer, said he did not know what had caused it. “I really have no answer for that, but it would be interesting to know,” he said.

Some take heart in the fact that the circuit breakers often work well. “With all the millions of different trades out there, we have only a dozen of these,” said Patrick Healy, chief executive of the Issuer Advisory Group. “It’s actually pretty good.”

But critics worry that the string of mini flash crashes points to deeper problems in the nation’s stock market.

“It’s like seeing cracks in a dam,” said James J. Angel, professor at the McDonough School of Business at Georgetown University. “One day, I don’t know when, there will be another earthquake.”

Andrew W. Lo, director of the Laboratory for Financial Engineering at M.I.T., said: “I am worried about the potential instability that these technologies create in market dynamics. The U.S. equity markets have become the Wild, Wild West.”

In May, the stock market drop of more than 700 points wiped billions off share prices in minutes, before bouncing back just as quickly, leaving everyone grasping for answers. But even though regulators have identified the main source of the drop as a sale of a large block of futures contracts by a mutual fund in Kansas, some worry that today’s fractured electronic stock market has become so unstable that another large sale or a simple error could incite a broader crash.

They also worry about the possibility for manipulation by high-speed traders, especially in a market where trading has proliferated over more than a dozen exchanges and where shares change hands in microseconds.

“What we have today is a complete mess,” said Thomas Peterffy, chief executive of Interactive Brokers, one of the largest brokerage firms in the country. “Over the last 10 years, technology delivered great benefits, but in the last year or so, it is not so good. There is more room for the various games some people play.”

This month, a software update at the New York Stock Exchange’s electronic Arca exchange brought a nearly 10 percent plunge in an exchange-traded fund that tracks the Standard & Poor’s 500-stock index.

In all the mini flash crashes, trades that took place after the plunge were canceled.

Most of the mini crashes were blamed on computer malfunctions or human error. But in at least one case, markets behaved as they were supposed to.

On Sept. 14, the stock of Nucor, a steel company based in Charlotte, N.C., was at $35.71 when it started falling. A trader had entered a large single order to sell without any price limit on the stock exchange of the Chicago Board Options Exchange. As would have happened on any electronic exchange, after the exchange, then known as the C.B.S.X., exhausted all the buyers on its own exchange, its computers looked to, or “swept” other markets for potential buyers before returning to the exchange’s own order books, eventually driving the price all the way down to a penny.

“Before May 6, exchanges frequently had transactions like this that were canceled or adjusted because of an erroneous execution price,” said David Harris, the exchange’s chief executive. “Compared to the total number of trades executed on U.S. markets, canceling a single transaction like this is statistically insignificant.”

Some in the industry think the use of unlimited orders should be controlled.

The authorities are contemplating other ways to make trading safer and are considering refining circuit breakers to stop erroneous trades from taking place.

A Securities and Exchange Commission official said the agency was closely watching the cases where individual stocks had set off circuit breakers, but had found that each case had “its own story.” The official added, “We are learning from them, and so far it is hard to extrapolate too much as to the general trends in the market.”

On Monday, the S.E.C. banned stub quotes, which were singled out for blame in the May 6 flash crash. These were place-holding price quotes, far from the market price, put up by market makers that are required to post quotes, but do not really want to buy or sell shares.

“While we continue to look at other potential obligations for market participants, this is an important step in our effort to improve the functioning of the U.S. markets and restore investor confidence following the events of May 6,” Mary L. Schapiro, the S.E.C. chairwoman, said in a statement.

The S.E.C. has also suggested imposing limits on high-frequency traders. Possibilities include requiring a minimum time for them to keep their orders in the markets, and obligations to offer buy and sell prices even when markets become volatile.

Critics suspect some high-frequency firms of “quote stuffing,” or firing off and immediately canceling thousands of orders each second to deliberately clog an exchange.

The sudden withdrawal from the markets by high-frequency traders during the market panic on May 6 worsened the decline.

Some critics say ordinary investors are becoming wary of the stock market. In a market dominated by lightning-quick traders with immense computing power at their fingertips, the odds are stacked against them, they fear.

Retail investors have pulled billions of dollars from stock market mutual funds this year.

The Investment Company Institute, which represents investment companies like mutual funds, said it was concerned by the “market inefficiencies” revealed by May 6 and wanted regulators to look at what it called abusive practices, like using technology to detect trading of large blocks of shares by investors like mutual funds and trading ahead of them.

Others are far more blunt. “I am very upset by the flash crash,” said George P. Schwartz, who manages the Ave Maria mutual funds. “I am upset by how high-speed traders have taken over the market. They make a mockery out of capitalism.”