'Flash Crash' Safeguards Could Leave Some Small Investors in the Lurch

Another risk left unaddressed in the pilot program involves "stop-loss" orders, a common way small clients establish, through retail brokerages, a threshold for how much pain they can endure when a stock they own falls. A stop-loss order triggers what is known as a "market order," an order to unload at the last prevailing quoted price. In a fast-moving, fragmented market that has far more sellers than buyers, prevailing quoted price levels can get flooded at eye-blink speeds; when no buyers step in to snap up shares, the levels automatically get pushed further and further down so that ultimately, and in mere seconds, the last prevailing quotes can sink to as little as one penny.

That's what happened with shares of Accenture, Inc., on May 6. The stock was trading at around $40 on the NYSE when the exchange's own existing circuit breakers kicked in. As sell orders got swiftly rerouted to various other exchanges where there were no speed bumps, price levels melted down.

Testifying May 20 before the Senate about the flash crash, Larry Leibowitz, chief operating officer at the NYSE, warned of the dangers of market orders in a panicked market.

A Starting Point

"Brokers should review their order-routing practices to ensure they are truly getting the best prices for their clients, and also see whether allowing market orders and stop-loss orders really service the investing public, or whether there are things we can jointly do to educate and protect retail investors from being the victims of volatile markets," said Leibowitz.

Asked about the possible pitfalls of a circuit breaker pilot program that doesn't include ETFs and does not address stop loss/market order issues, NYSE spokesman Ray Pellecchia said, "We had to start somewhere."

"Let's get this in place for the stocks in the S&P," he said."Then make sure it's working properly, then assess it, and expand it further."

Evolution of a Fast Market

Stock market panics are as old as stock markets themselves. For more than two centuries the U.S. market mainly revolved around the NYSE, where human traders called "specialists" made markets by trading face to face with floor brokers, each group extracting a cut from the spread between what buyers and sellers were willing to pay to get a transaction done.

Flash forward to the 1970s and 1980s and the rise of computer technology. An entirely new, electronic market sprang up, the NASDAQ, which in turn gave rise to other electronic markets, so-called electronic communications networks, or ECNs.

By the mid-1990s, the Securities and Exchange Commission began to tweak market rules to allow smaller investors to trade with one another electronically and away from the floor of the NYSE. This gave rise to new, faster, more technology driven all-electronic markets, such as ArcaEx, which was a game changer for the stock market (and which is now owned by the NYSE).

Big institutional investors applauded the trend to move trading away from the NYSE floor, which was seen as a venue where the best price wasn't always obtainable. Human traders were not necessarily incentivized to match natural buyers with natural sellers at ideal price points. That's because doing so ate into their ability to profit from being in the middle of the trade.

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