June 18, 2010 -- An experimental circuit breaker program starts next week to slow superfast electronic stock markets during episodes of severe volatility. Regulators say they plan to monitor any unforeseen outcomes and learn from them.
But already there are large players on Wall Street warning of potential pitfalls, and it's the small investor, not large hedge funds, who could be most vulnerable.
One major concern, for example, involves exchange-traded funds, or ETFs. These are essentially mutual funds which trade on exchanges the same way a single stock does. The new circuit breakers will only apply to the individual stocks in the Standard & Poor's 500, not other stocks, and not ETFs -- not even ETFs that are comprised of stocks in the S&P.
A situation in which S&P stocks, but not ETFs linked to them, get halted in a market meltdown might leave ETF owners, many of them small "buy and hold" investors, susceptible to a spill-over of panic selling. This, in turn, could conceivably trigger scary, nearly instantaneous share-price implosions, or exactly what market regulators are trying to prevent.
That's just what happened May 6 when the stock market suddenly dropped, and then suddenly recovered. The Dow Jones Industrial Average, a benchmark of 30 blue chip stocks, fell nearly 700 points in a matter of minutes that afternoon, part of a larger, staggering intraday decline of nearly 1,000 points, the largest such decline ever. The Dow did rebound that day, making up around two-thirds of the point loss but leaving market participants more than a little spooked.
This event, dubbed the "flash crash," still has not been entirely explained. In the aftermath, regulators moved at what for them was light speed to create a pilot program to halt trading automatically in S&P stocks that experience 10 percent moves, up or down, in any five minute period. It's well intended, but, industry members say, may have unintended consequences.
Systemic Risk Left on the Table
"Our biggest concern is that ETFs are not included in this program," said Gus Sauter, chief investment officer at the mutual fund giant Vanguard, which manages roughly $1.4 trillion in assets, including $105 billion in ETF assets.
"In a panic selling situation, with trading of some stocks halted but not the ETFs, we could end up with ETFs that get pummeled to absurd, panic levels like we saw May 6. We're still leaving a lot of systemic risk on the table."
The Securities and Exchange Commission is overseeing the creation of the circuit breaker pilot program along with various exchanges, including the New York Stock Exchange, Nasdaq, and 10 other exchanges, such as the ISE, CSX and BATS, as well as the Financial Industry Regulatory Authority, which governs brokers. Eventually, if all goes to plan, the circuit breakers are going to be expanded to non-S&P stocks and ETFs, the SEC has said.
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.
With more orders moving away from the floor, more electronic markets sprang up, with big Wall Street banks creating their own versions of ArcaEx and their own internal pools for electronic trading. At the same time, trading became more automated, driven by computer programs. Where once stock markets were controlled by a group of humans gathered in one centralized place, the NYSE, by the middle of the last decade there were numerous electronic markets and humans were largely made irrelevant by computers.
Mind the Gaps
When the flash crash occurred May 6, NYSE traders and other critics of market structure changes claimed that the rise of computerized, fragmented markets had come back to bite investors.
The NYSE's circuit breakers (known as liquidity replenishment points) were triggered, but other exchanges such as the Nasdaq didn't have them, which in turn caused orders to be rerouted there and to other exchanges that also did not have speed bumps.
Between automated trading and the lack of uniform market controls, certain stocks melted down.
Bringing a fast, fragmented market together with some uniform "go slow" safeguards in extreme conditions is at the heart of the circuit breaker pilot effort, the NYSE's Pellecchia said. "We'll learn from this pilot program and take necessary steps to improve," he said.
Dick Del Bello, senior partner at Conifer Group, a New York-base securities trading firm, said the pilot program is a good start, but eventually it will need to be expanded.
"If it's done across the board it will be effective," Del Bello said. "When there are gaps, they get filled. That some stocks are subject to time outs and others are not … that could lead to problems."