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_____________________________________________________________________________
Proposal for Reform: Rules and Regulations
to protect electronic exchanges from
experiencing technical failures similar to
those occurring on
May 6, 2010.
Bloomberg Research Journal
100 F Street, NE
Washington, DC 20549
Jason KirschMiami UniversityFarmer School of Business
December 2010
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ABSTRACT
This report evaluates the May 6, 2010 flash crash and details preventative actions that
should be considered immediately. Further study into the matter targets high frequency
computerized trading programs as the main culprit. The underlying assumption of my proposal
is that greater control of market prices can be attained by transferring power from computers to
humans. Holding this assumption, the report pitches six reforms that should be administered
immediately. Each proposed reform has been developed to meet specific criteria in that the
alteration must provide clear benefits that must include enhanced transparency while not hurting
liquidity.
The transfer of power from high frequency trading systems to human traders will lead toward
a shift from unidentifiable back end costs to slightly higher front end costs. Further analysis lead
toward six major preventative measures that meet the necessary criteria. They are as follows.
1. Adding a three second pause before trade execution would ban the process of quotestuffing and allow more transparent price quotes for securities.
2. Installing circuit breaker systems on major and private exchanges would prevent bigdrops in prices by pausing market trades if the price of a security fell more than 10% in a
15 minute span.
3. Enforcing a maximum spread less than or equal to 50 basis points will increasetransparency and limit the momentum of price movement in down markets.
4. Enforcing stricter short-sell rules would limit the incentive for traders to put downwardpressure on prices because they would not be able earn a great profit on the fall of prices.
5. Cutting taxes for major exchanges that promote non-computerized trading will reduceincentive for exchanges to push computerized trading in which they earn greater profit
from high volume of trades.
6. Creating an audit trail for institutional traders might prevent harmful trades by greaterlaw enforcement.
Intensive research enforces powerful arguments in favor of each reform mentioned in the
report. Further explanation on the benefits and costs of each reform can be found in the body of
the report. These reforms should provide necessary measures to prevent events similar to those
occurring on May 6, 2010. With strict enforcement, markets should experience more favorable
conditions.
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CONTENTS
1. INTRODUCTION TOTHE EVENTS ON MAY 6, 2010Pg. 42. CAUSES OF FLASH CRASH Pg. 5-63.RULES AND REGULATIO NS Pg. 6-94. CONCLUSIONPg. 10
A.SUMMARY CHARTPg. 11B.BILIOGRAPHY Pg. 12C.GLOSSERY Pg.13
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INTRODUCTION TO THE EVENTS ON MAY 6, 2010
Earlier this year, a monumental event tested the adhesiveness ofAmericas financial
engine, Wall Street. The Dow Jones Industrial Average dropped nearly one thousand points
within a one hour time frame. Hundreds of stocks lost more than sixty percent of their value
while investors sat powerless on the sidelines. As financial professionals realized they had lost
control, flight or fight mode took over. Confusion was the only barrier to total chaos. By the end
of the trading day, the market regained most of its losses while talking heads were already
starting to lay blame. Investors all over the world sat in high anticipation of the Securities and
Exchange Commissions actions.
Exhibit 1
Five months later, the SEC released a well-crafted report with intent to restore
confidence. While mainly focusing on causes of the crash, their goal was not accomplished.
Instead the lengthyreport created more uncertainty among investors, causing the public to lose
faith in the SEC. Many argued if the SEC would ever strive to prevent an event like this in the
future. Desperate for reform, congressmen all over the nation started to argue for major changes
to system. Currently not much has changed to theAmerican financial system. An event similar
to the May 6, 2010 Flash Crash could occur at any moment.
Today, action is needed to prevent future technical failures in our markets. Another
market wide panic can not only slow economic growth but has a high possibility of sending
America into a depression. By adopting the six reforms mentioned in the body of the report, the
SEC will be stepping in the right direction, the road leading to a stronger economy.
The Chart to the right
shows the price of the Dow
Jones Industrial Average
over the market hours of
May 6, 2010
Source:Yahoo Finance
05/06/2010
www.Finance.Yahoo.com/F
lashCrash
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CAUSES OF THE FLASH CRASH
The market setting on the morning of May 6th was filled with worried traders. Investors
were in panic over the sovereign debt crisis sweeping over Europe that led to deterioration of
investors previous gains. Because of high uncertainty, institutions were pressuring traders to bepatient while working under strict caution. Intense fear pushed investors to sit on the sidelines
while traders found their job to be more difficult due to extremely low volume. The market was
waiting to pounce on the next event, whether good or bad.
Exhibit 2
The official report laid blame on a single trading firm, labeling them the spark of the
crash. The SEC outlined the scenario where a firm in Chicago executed a large directional trade
based upon an attempt to profit from a market mispricing. The unordinary scale of volume
tricked automatic computer trading programs to place large sell orders, putting downwardpressure on market prices. The players responsible for filling these trades used automatic trading
programs as well. Before human traders could do anything, market prices were already at
bottom. Stocks of corporations such as Proctor and Gamble, Boston Beer and Nordstrom
dropped to pennies per share before recovering. Realizations that the drop in prices could not
reflect true value sent the prices back near normal. Because capital markets are interconnected,
the changes in stock prices cause changes in market prices of non-stock assets. For example, the
change in the S&P500 index sparked a more volatile exchange rate between the U.S. Dollar and
the Euro (shown in the Exhibit 3). At the end of the trading day, the SEC released news stating
they will restore positions on stocks affected by the crash to pre-crash levels.
The chart to the left shows
volume of the Dow Jones
during the Day of the flash
crash. Notice how the volu
(shown in teal) is much low
that morning and then spik
up. Volume
Source:Bloomberg; 05/06/2010 www.Bloomberg.
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Exhibit 3
After much argument, the financial industry began to accept that high frequency
computerized trading was the primary reason why the markets lost control. These systems makedecisions based on specific variables faster than humans could realize what has occurred. While
these programs generated higher profits for firms and lower upfront transaction costs they also
led to dangerous unidentifiable back end costs. These back end costs, since unidentifiable and
unexpected are more toxic to markets.
Exhibit 4
However measures taken to prevent another technical crash do not need to include a ban
of high frequency trading systems. Restrictions on how these systems are used offer enoughsafety while greatly saving the benefits. Two hazardous operations done via high frequency
trading systems are Quote Stuffing and Stub Quoting. Quote stuffing is a common
procedure by proprietary trading firms that use high frequency trading algorithms to send out a a
large volume of bids only to retract them immediately after. These bids usually give false
signals to investors on price direction. For example, if a firm sends out a large amount of buys
above the market price, investors see that other investors would pay more money for the security.
The chart to the left represen
the change in the Euro to Doll
exchange rate during the pea
15 minutes in which the flashcrash occurred. This
demonstrates the level of
interconnection among the
stock market and the currenc
market.
To the left is an image of a single
control desk for a High Frequency
Trading System. Not shown is theserver room, which can take up
anywhere from 100 square feet to 80
square feet.
Source:motleyfoot.com; 05/06/2010 www.motleyfootl.com
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Quote stuffing leads to traders devaluing trends in prices. If a trader values these trends, they
might be able to execute a sell order at a higher price. Stub quoting is a method used by market
makers, who are parties that provide liquidity to markets for other governmental benefits. A
market maker is required to provide a quote above and below the market price in that they have
to fill either a buy or sell order. A stub quote is a place holder quote used by market makers that
is far from the market price. Their purpose is to fulfill their obligation, while making it unlikely
to execute the trade. By doing this market makers can bet on the direction of the market o profit
greater. Many traders do not see this as a negative because a greater profit increases market
maker competition and reduces transaction costs of trading. On May 6th, lower stub quotes were
filled before market makers could replace them. This gave momentum to the downward spiral of
prices. While providing benefit, unregulated use of computerized trading algorithms only creates
hazardous unidentifiable costs to investors.
RULES AND REGULATIONS
Global markets can benefit by stronger regulation of high frequency trading systems and
electronic exchanges. By transferring power from computers to humans and preventing
unordinary swings in market prices, markets will become less volatile, safer and more trusted by
investors. Following, I propose six reforms that clearly hold this assumption. All proposed
changes meet specific criteria in that the alteration must provide clear benefits that must include
enhanced transparency while not hurting liquidity.
Reform #1: Instating a mandatory clearing period of three seconds before trade retraction on
electronic exchanges.
One of the major functional reforms the market needs is a restriction on the act of
quote stuffing. By instating a three second period before allowing bid retraction, high
frequency operators will not be able to quickly retract their bids, and the trades can be
executed. The risk posed of possible execution should prevent the majority of quote
stuffing by firms who operate high frequency trading systems. Three seconds will not do
any harm to liquidity because the markets will always be three seconds delayed. Having
a clearing period will also prevent other types of market price manipulation that have to
do with false trade quotes. Since only electronic exchanges pose a problem, installing
this clearing service would be a low cost initiative.
Reform #2: Install and maintain circuit breaker systems on major and private exchanges.
Circuit breakers on electronic exchanges are necessary in damage control. The breakers
will stop trading on securities after certain criteria are met. After ten seconds, trading will
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resume again but follow the same restrictions. The system is considered an option of last
resort that wont stop a crash but will minimize damage and create more investor confidence.
Traders will be able to tell when a circuit breaker is triggered by signs in the market price.
Different criteria apply to different securities to keep up with natural volatilities.
1. Stocks priced $25 or less:Breaks if the trades are 10 percent away from the circuitbreaker trigger price.
2. Stocks priced $25 to $50:Breaks after 5 percent swing from the circuit breaker triggerprice.
3. Stocks priced $50 or greater: Breaks after 3 percent swing from the circuit breakertrigger price.
Circuit breakers serve our purpose as a band aid instead of a preventative measure.
History has shown that we should take advanced precaution no matter upon the
circumstance.With time certain market conditions might arise where circuit breakers will
prove of use.T
he cost to implement is next to nothing and possible side effects are of nosubstance.
Exhibit 5
Reform #3: Pose a maximum spread of 50 basis points on market makers Bid-Ask price quotes.
Aside from quote stuffing, stub quoting is a major hazard of high frequency
trading systems. Controlling market makers to place quotes within a certain price
interval will provide buy and sell prices that reflects true market price and therefore
increase liquidity. While creating more liquidity, markets will become less volatile
because quotes that are not meant to be filled wont be automatically filled by computers
and prices will fluctuate naturally. This reform could be done as easy as a signature.
There were circuit breakers in place during
the Flash Crash . However these circuit
breakers were not strict. The chart to the left
shows the amount of high frequency trades
that were blocked compared to the trades that
were executed.
Source:Bigcharts.com 05/06/2010
www.Bigcharts.com
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Since market makers only receive benefits if they accomplish their responsibility they
will have incentive to follow the regulation. However this regulation will lower profits
by these liquidity providing firms. By heavily regulating this change, natural and
effective competition will increase and firms specializing in market making will need to
innovate to succeed. Over time upfront prices will be as low as before.
Reform # 4: Ban the act of Short Selling.
Short selling is the process where an investor sells a security without actually
owning the security. The investor is given the ability to short sell by brokers allowing the
investor to borrow the security from another investor, with terms to return the same
security in the future. Investors profit on short selling by selling the borrowed security at
a higher price than they return it at. Short selling creates more volatile markets because it
allows investors to profit quickly on falling prices. By selling securities that would not
normally be sold, great downward pressure is put on market prices. Short selling gives
investors great incentive to push market prices downward. This almost always leads to adownward spiral effect when there is a drop in market prices.
By banning short selling the government would not ban ways to profit on
downward markets. However to accomplish this feat, the investor would have to execute
more timely trades that would have much less of an impact on volatility.
Reform #5: Cut Federal taxes for exchanges that do not allow high frequency trading systems.
Many experts believe that banning all use of high frequency trading would cause
great short term damage to the economy. Currently, our economy is not strong enough to
handle such a drastic change. However, providing incentives to electronic exchanges to
control the use of high frequency systems can slowly reduce global reliance. Cutting
federal taxes for exchanges that do not allow, or disapprove use of high frequency
computerized systems can jumpstart a major trend in the market. Exchanges will have
enough incentive to begin to promote the shift in power from computers to humans.
While our economies health does not currently rely on this transition, it can offer
great benefits in the future. The slow transition would not harm liquidity while it would
make markets more efficient and transparent. Human traders will be forced to survive by
developing innovative practices that do not use automated systems. Over time our
markets will become more efficient and much less risky.
Reform #6: Impose a mandatory Audit trail for all institutional traders who manage over five
million U.S. dollars of capital.
One reason for unorthodox and sometimes unethical market practices is weak
enforcement by the Securities and Exchange Commission. More stern enforcement will
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provide more risk of consequence for unethical and unorthodox behaviors. Since the
SEC has fixed resources, the most cost effective way to enforce market practices is
through audits. By implying mandatory auditing for institutional traders, traders are less
likely to take selfish action that might hurt the markets. Aside from discovering fraud
and unethical practices, the SEC can use this as a way to further learn how Wall Street
functions. Auditing institutional activity will also provide more business for accountants
by expanding the area their service covers. The cost is cheap, the downside is limited and
the benefits are great.
CONCLUSION
Nobel Prize winning economist Paul Krugman once said Greater use of computers has
propelled the growth of our economy while greater reliance will ignite its downfall . It is now
clear that the market crash on May 6th, 2010 was caused primarily by reliance on computerized
trading. Regulation of these computer systems is the best way to control markets to make them
more efficient.
The six reforms previously outlined can jumpstart the transition into a better controlled
market. While each change has individual benefits, together they should create market
synergies. Theyprovide necessary measures to prevent technical failures so our markets do not
experience a more devastating Flash Crash. Together, these reforms should create a more
liquid, transparent and effective market. With strict enforcement, markets should experiencemore favorable conditions.
The May 6th Flash Crash was a major warning that computerized operations should not be
relied on. Experts already know, in theory, the science behind the fastest possible computer.
When humans reach that point, a long lasting depression might be in store. While instantly
demolishing computerized trading systems would send our economy into frenzy, promoting a
change away from computer reliance will without doubt benefit global markets. More individual
power has the potential to evolve the lines of human competition from who can create the
smarter computer to who can control it.
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Reform Description Benefits
Instating a mandatory
clearing period of threeseconds before traderetraction on electronicexchanges.
A threesecondclearing period
willincrease transparencywhileminimizing quotestuffing
activities. Theclearing period
prevent intentional
cancellationsand willimprove
liquidityconditions.
Minimizationoftheact ofQuote Stuffing
Reduces VolatilityLow Cost
Givemore power toindividualinvestor
Install and maintaincircuit breaker systems onmajor and privateexchanges
Circuit breakers willact asaact
oflast resort. Theyareasafety
net, capableofstopping
maniasand panicsandare
usefulincreatingconfidence
amonginvestors.
Provides Damage Control
Reduces Volatility
Raiseinvestor Confidence
Pose a maximum spreadof 50 basis points onmarket makers Bid-Askprice quotes.
A maximumspread will
increasecompetitionamong
market makersand therefore
increaseliquidity. A maximum
spreadalsoeliminatesstub
quotingandreducesvolatility.
Minimize Stub Quotingby Market Makers.
Increased Liqudity
Low Cost
Reduces Volatility
Promote Natural Market Cycles
Greater Transparency
Ban the act of ShortSelling.
Eliminatingshort selling will
most important create
incentiveforupward pressure
onstock price. Thisleads to
greaterinvestment profit,
government taxrevenueand
growth. It willminimize
unethicaldecisionmakingand
transparency.
Reduces Volatility
Createsmoreopportunitiesforinvestment
Reducesunethical pricemanipulation
Increasesincentiveforstock pricegrowth that
canlead togreaterinvestment.
Will Increase Transparency
Cut Federal taxes forexchanges that do notallow high frequencytrading systems.
A taxcut forelectronic
exchanges willcreateincentive
for them tomove towards
human trading. It willcause
greatercompetitionand
identifiableandlowerlong
term transactioncosts.
Providesincentive tobegin the transitionof
powerfromcomputerizedsystems to
professionals.
Canlead tofuturebenefits
Lead towardamorecompetitive Market
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Sources for Research
All-In-One Source
"Flash Crash."Wikipedia.Web. 19 Oct. 2010. .
Explanations of Events that Occurred on May 6, 2010Bommarito, Michael. "SPY Flash Crash Summary."Seeking Alpha: Bommarito (2010). Web.19 Oct. 2010. .
Caldwaller, Amy. "Data Wonks Debut Dizzying Diagram of Flash Crash."WallStreet Journal27 Sept. 2010. Print.
Caldwaller, Amy. "Dow Takes Harrowing 1,014.14 Point Trip."WallStreet Journal06 Aug.2010. Print.
Durden, Tyler. "SPY Flash Crash: NYSE Cancels Trades."Zero-Hedge.com. Zero Hedge (TylerDurden). Web. 19 Oct. 2010. .
"Econobrowser:Causes of Flash Crash." Econobrowster. 02 Oct. 2010. Web. 19 Oct.2010. .
Zeiger, Timothy. "SEC Probes Cancelled Trades."WallStreet Journal27 Sept. 2010. Print.
Factors that might of caused the Flash Crash
Mason, Christopher. "Investors, Regulators Laid Path to Flash Crash."WallStreet Journal29Sept. 2010. Print.
Regan, Michael. "NYSE Software Glitch Spurs $7.9 Billion Misprice in S&P 500 ETF." Bloomberg.com. Web. 19 Oct. 2010. .
Future Regulations to Prevent Similar EventsPatterson, Scott. "Legacy of Flash Crash: Enduring Worries ofRepeat."WallStreet Journal06
Aug. 2010. Print.Pewter, Maria. "Limit System May Replace Circuit Breakers."WallStreet Journal24 Sept.
2010. Print.Ratner, Hank. "SEC Urged to Tighten Market-MakerRules."WallStreet Journal12 Aug. 2010.
Print.Youngei, Rachel. "SEC Brushes Off Flash Crash Report Critics."Reuters.com.
Impose a mandatoryAudit trail for allinstitutional traders whomanage over five millionU.S. dollars of capital.
Auditinginstitutional traders
will prevent unethical
behavior. Thegovernment will
alsobetterunderstandinsider
practices tobeable toregulate
moreefficiently.
Minimizeunorthodoxandunethical practice.
Promotesmoreinvestment byindividuals.
Increases Liquidity
Creates Revenue
Leads to Greaterunderstandingandinformation
sharing.
Limited Downsideand Low Cost
Summary of Reforms
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Thompson Reuters.Web. 19 Oct. 2010. .
Official Documents
"SEC Official Market Report for Events on May 6, 2010."SECOfficial Website. SEC, 2 Oct.
2010. Web. .
Glossary Terms
Audit the evaluation of a person, organization or process in order to make sure specifics are in
line.
Bid- Ask Spread The difference between the price that a market maker buys a security and the
price that they sell that same security.
Circuit breaker an automatic switch designed to pause market activity when an abundant
amount of volume is being generated.
Dow Jones Industrial Average A widely used stock index that represents thirty of the largest
corporations.Is used by investors to represent the change in value of larger stocks.
Electronic exchange A non physical location where people buy and sell securities. This is
usually dont over complex computer systems.
Liquidity The ability to sell an asset at market value relatively quickly.
Market maker Traders who receive benefits from exchanges to provide a quote to buyers and
sellers in order to create liquidity.
Points an indicator representing the price of a group of securities.
Quote stuffing A technique whereby large volume of trades are placed before being
immediately cancelled. Quote stuffing is mainly used by institutional investors that want to send
false signals.
Security A claim to an asset that is traded through an exchange or between two parties.
Stub quotes an order at a price far from the current market price. Stub quotes are used by
market makers to fulfill their responsibility while giving them the ability to bet on the direction
of the price.
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Transparency the ability for individual investors to receive the same information as the rest of
the market.
Volatility Amount of deviation from the market price throughout a time period.
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