Fear Of The Unknown Persists In Flash Crash Legacy

A year after the May 6 "flash crash," securities industry officials and regulators agree another market calamity couldn't unfold in the same way. But fears of other, unknown pitfalls persist.

While exchanges have a raft of new rules to show for the work that went into unwinding the mysterious plunge and more will come, the web of trading venues now stretches further and regulations are more complex than a year ago, when the flash crash revealed seams in the U.S. trading system.

"It still echoes," said Peter Bottini, head of trading for the online brokerage OptionsXpress Holdings (OXPS), which counts nearly 400,000 customer accounts.

The sudden gyration chopped 700 points from the Dow Jones Industrial Average over the course of 20 minutes--temporarily erasing nearly $1 trillion in equity values--and took regulators five months to fully explain, though new rules were crafted within weeks to fix the most glaring problems with the structure of U.S. financial markets.

Stock prices no longer can range more than 10% in a five-minute period without hitting a "circuit breaker" that prompts a time-out in trading. Exchanges agreed to uniform guidelines on when to void transactions made in error and firms no longer can lodge placeholder orders that offer to buy securities at outlandish prices such as one cent--producing some of the more embarrassing moments of that afternoon a year ago.

"It's gone a very long way to prevent another flash crash," said Chris Nagy, who oversees trading issues for TD Ameritrade Holdings Corp. (AMTD), the Omaha-based brokerage with eight million retail accounts.

A year later the U.S. stock market--ground zero in the flash crash--is a quieter place. About 7.1 billion shares changed hands last month, down from 9.8 billion in April 2010, as activity tapered off after last May and stayed lower. A pullback in institutional investing has given computer-driven firms fewer transactions to trade against, reducing their slice of market volume to 53%, according to estimates from research firm Tabb Group, down from about 66% a year ago.

It's also a more fragmented and complex landscape. Two new stock exchanges came online last fall and Credit Suisse (CS) introduced a major new electronic trading platform. Regulations addressing the flash crash alongside new rules for short-selling and risk controls have pressed trading firms to keep compliant, with more potential rulemaking seen around the role of the busiest electronic traders, and further refinements of the circuit breaker system.

"We have a lot of other issues we want to continue to pursue to bolster and fortify U.S. equity market structure," Securities and Exchange Commission Chairman Mary Schapiro told reporters after a congressional hearing this week.

Schapiro has indicated a key priority in the coming months will be to finalize two proposals--a consolidated audit trail for orders and executions across all markets and a system to allow the SEC to track the activity of large traders. Both would give the regulator real-time market data, allowing it to reconstruct market meltdowns faster.

"Without a doubt the flash crash made a consolidated audit trail relevant," Security Traders Association Chairman Joseph Cangemi said. Regulators needed five months to construct a microsecond-by-microsecond rehash of May 6, in part because they had to gather data from dozens of trading venues.

But fears of another unforeseen meltdown persist, particularly among companies who saw their shares wildly whipsawed in the flash crash. "There is a continued heightened level of concern at the issuer level," said Bob Greifeld, chief executive of Nasdaq OMX Group Inc. (NDAQ), which outlined new guards for Nasdaq-listed shares last June.

Warnings have also been sounded that flash crash fixes have not been fully thought out. The SEC's push to evolve circuit-breakers to a new system that will limit trading within a narrow price band has drawn criticism from CME Group Inc. (CME), the world's biggest futures market operator.

CME has warned that curbing trade in specific securities that are components of major indexes could make those measures--and the derivatives that are linked to index values--less reliable, increasing uncertainty during turbulent moments.

"We believe there are important unintended consequences with this approach," said CME's Chief Operating Officer Bryan Durkin, speaking in Washington Thursday.

Scott O'Malia, a member of the Commodity Futures Trading Commission and chairman of a group focused on market technology, this week said that regulators and exchanges should think about ways to coordinate practices across borders to guard against a flash crash episode cascading internationally.

But with the immediate threat of a repeat flash crash largely addressed, many in the securities industry hope regulators will now return to some broader issues regarding the structure of the markets.

NYSE Euronext (NYX) Executive Vice President Joseph Mecane said there remain big picture issues for the equity markets that need to be addressed, such as rules for so-called dark pools, or anonymous trading venues. The SEC had proposed in late-2009 changes to rules on dark pools, but these were pushed to the side last spring; also on the shelf is a proposed ban on "flash" order types.

The role of electronic, liquidity-providing traders--heavily relied upon to ensure other investors can buy or sell securities or derivatives--is another outstanding matter that needs addressing, said OptionsXpress' Bottini.

"We definitely need the regulators and the politicians to carve out some new rules to deal with the new realities in the marketplace," he said. "More than any of the issues with the flash crash is the fragmented liquidity across venues and that still exists right now."

-By Jessica Holzer, Dow Jones Newswires; 202-862-9228; jessica.holzer@dowjones.com

Optionsxpress Holdings, Inc. (MM) (NASDAQ:OXPS)
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