Commentary: What's Old is New Again
More on the SEC and CFTC's Report on Flash Crash
Traders Magazine Online News, June 1, 2010
In the last week of April, we wrote a column about the recently proposed Large Trader Reporting Rules, which were originally trotted out in 1991 in response to the 1987 Black Monday equity market collapse. We pointed out that other changes to equity market regulation and market structure had succeeded in preventing another market collapse, even during the unusual trading volumes and patterns that resulted from the Panic of 2008. We therefore argued that the proposal was unnecessary, amounting to an expensive solution in search of a problem.
No sooner was the ink dry on the page when the "flash crash" occurred. On May 6, 2010, during a 20-minute period in the afternoon, the Dow Jones Industrials dropped about 700 points and then recovered, ending at about 350 points down on the day. A handful of stocks were especially volatile, including such blue chip conglomerates as Procter & Gamble and 3M.
The role of markets in a capitalist economy is to determine a value for things. Securities markets reflect investor expectations about the effects of future events on corporate earnings capacity. While investors have plenty to be gloomy about lately, it is difficult to argue that investor expectations dipped more than 5% in a matter of minutes and then recovered when there was no shocking news to explain the change in sentiment. It seems clear that for a brief period of time, the equity markets failed to determine values that accurately reflected investor beliefs.
When markets are functioning properly, we prefer that regulators keep their hands off them. When markets fail, we expect that the regulators will do something about it. Congress immediately responded by summoning Mary Schapiro and Gary Gensler, respective heads of the SEC and CFTC, to explain what happened and what they planned to do about it. Their answer was that they didn't know and hadn't yet developed a plan. But, they were working on it.
On May 18, 2010, the SEC and CFTC confirmed this puzzle in a report entitled "Preliminary Findings Regarding the Market Events of May 6, 2010," which interested readers can download from the SEC's website.
The report pointed out that one of the reasons the SEC and CFTC had not yet determined the cause of the crash is that the Large Trader Reporting rules have not been adopted: "Although trading now occurs in microseconds, the framework and processes for creating, formatting, and collecting data across various types of market participants, products and trading venues is neither standardized nor fully automated." Of course, the SEC's rules would not require reports on futures trading because it has no authority to regulate futures. The CFTC, which does regulate futures, already has Large Trader Reporting rules, although the reporting is not automated. The CFTC is planning to address that in future rule proposals. It seems that the solution has finally found a problem to solve.
In the meantime, the SEC and CFTC have four "working hypotheses" as to the cause of the crash.
The first of these theories is that activities in stock index futures - especially index ETFs and E-mini S&P 500 futures - were linked to simultaneous and subsequent waves of selling in individual securities. And, in fact the CFTC has located one trader that sold a lot of E-mini S&P 500 futures during the flash crash episode. Of course it's not entirely clear how selling futures indices would result in a precipitous decline in the common stock of Proctor & Gamble, 3M and Accenture, without affecting other S&P 500 stocks much at all.
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