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December 16, 2010

2010 Review: The Day That Changed Everything

By John D'Antona Jr.

May 6, 2010, is a day that will long be remembered by investors. Known as the "flash crash," the events that unfolded that tumultuous trading day will likely shape equities trading for the next several years.

It was a spring day, with temperatures running around 70 degrees and a slight westerly breeze. The weather was calm and clear, but the equities markets were anything but.

According to the official joint Securities and Exchange Commission and Commodities Futures Trading Commission report, the crash was caused by a 75,000-contract, algorithmic trade in E-Mini contracts by an institution. At 2:32 p.m., against a backdrop of unusually high volatility and thinning liquidity, a money manager began selling the E-Mini contracts, valued at approximately $4.1 billion, as a hedge to an existing equity position. The algorithm executed its sales in just about 20 minutes.

During the height of the flash crash, the Dow Jones Industrial Average dropped almost 1,000 points. The market then recovered, ending day down 342 points. But once the dust settled, the market's behavior came under intense scrutiny, as investors, politicians and regulators all wanted answers about what had happened and why. Hearings were held in Washington, D.C., by regulators and Congress. Finger-pointing began, and potential solutions were hashed out in the press and behind closed doors. The SEC and CFTC issued their long-awaited report in October. And the report's findings were subject to criticism, in that it didn't directly advocate solutions.

Matt Andresen, co-chief executive officer of Headlands Technologies, an electronic quant trading firm, said the SEC/CFTC report met its mandate: to provide a factual account of what happened.

"So, the Commission took immediate direct action to address the embarrassing aspects of the flash crash," Andresen said at a recent industry conference.

And that was good. But the fallout from May 6 continues, as regulators continue to float ideas that might help avert another market meltdown. One such proposal is limit up/limit down, which provides price bands on individual orders. Others topics discussed include time in force for quotes and a re-examination of market-maker obligations.

Either way, the event continues to stir debate about whether the markets are too fast and whether certain investors are disadvantaged because of it. What should be done? It's not clear what will happen.

Even before May 6, the SEC was already concerned that the activities of short-term traders might be harming long-term investors. In its Concept Release issued in January, the securities industry's top cop divided the trading world into two camps: short-term and long-term investors. It questioned whether the speedy first group was putting the second group at a disadvantage.

Advocates for short term traders cried "No!" but the events of May 6 didn't help their cause. By June 10, the SEC was making ominous noises about speed limits.

At the annual meeting of the International Organization of Securities Commissions in Montreal on that date, SEC chairman Mary Schapiro told the gathering the commission was investigating whether it would regulate speed. The SEC, Schapiro said, would "explore whether bids and orders should be regulated on speed so there is less incentive to engage in this microsecond arms race that might undermine long-term investors and the market's capital-formation function."

While the increased speed of trading is cited as a natural outgrowth of the drive toward efficiency, there are many who believe trading at warp speed is going too far. They contend that the stock market exists to match long-term investors with businesses seeking to raise capital, and that hyper-fast trading conditions breed speculators who only make raising capital more costly for corporations.

Michael Goldstein, a professor at Babson College in Boston, explained that batching trades not only allows traders a brief moment to check the markets, but to double-check for events that algorithms aren't programmed for-such as something that dislocates pricing, like a national catastrophe.

"Trading happening at one millisecond or faster isn't the purpose of the stock market," Goldstein said. "It's to allocate capital, and I believe it hasn't been doing that any better than in 2007 when markets were slower."


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