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April 1, 2011

'Flash Crash' Report Under Fire

By Peter Chapman

Also in this article

  • 'Flash Crash' Report Under Fire
  • Page 2

Market structure recommendations from regulators drew guarded praise from one group of affected parties and scorn from another. 


The recommendations came from an advisory committee sponsored by the Commodity Futures Trading Commission and the Securities and Exchange Commission. The group's February report is intended to serve as a road map for regulators searching for ways to prevent another market flip-flop like the flash crash of May 6, 2010. While many of the 14 recommendations are already in rule form or have been agreed to in principle, a few are likely to produce vigorous debate.

Those recommendations already in rule form include putting circuit breakers on individual stocks; making updates to clearly erroneous trade rules; banning so-called "stub" quotes; a ban on naked access; and a proposal for a consolidated audit trail. Those still in the idea stage, but considered likely to become rules, include limit up/limit down functionality and a revision of existing marketwide circuit-breaker rules.

Any fireworks are likely to come as a result of the report's third section, which focuses on maintaining market liquidity. The committee targets both high-frequency traders and broker-dealers that internalize order flow.

For HFTs, the group suggests that the SEC consider encouraging firms engaged in market-making strategies to maintain bid and offer quotes that are "reasonably related to the market." Previous suggestions to mandate quoting have been criticized by some high-frequency traders as anticompetitive and bad for the market. In their report, the committee suggests that encouragement could come in the form of pricing incentives rather than by regulatory fiat. The committee suggests the exchanges institute "peak load" pricing schemes to draw liquidity at the times of greatest needs.

For one group of HFTs, such language is encouraging. "We agree with the committee's conclusion that market-based incentives are more effective than mandatory obligations in promoting well-functioning markets," members of the Futures Industry Association's Principal Traders Group said in a statement.

An idea unlikely to receive FIA PTG support, however, is cancellation fees. The joint committee also believes the SEC and the CFTC should explore the idea of implementing uniform cancellation fees across exchanges. Placing orders and immediately canceling them is standard operating procedure for many HFTs.

As for the internalizers, the committee recommended that the SEC consider adopting a trade-at rule. Because a lack of liquidity was at the heart of the flash crash, the committee reasons that forcing brokers to send more flow to the public markets would be helpful. A trade-at rule would require brokers to either offer significant "price improvement" to their incoming orders or route them to the exchanges.