Financial Regulatory Forum

BREAKINGVIEWS-Market turmoil recalls 1987′s electric nightmare

By Reuters Staff
May 7, 2010

– The author is a Reuters Breakingviews columnist. The opinions expressed are his own –

By Nicholas Paisner

LONDON, May 7 (Reuters Breakingviews) – The cancellation of share trades by a stock exchange has a third-world feel about it. But Thursday’s unfeasibly large swings in some U.S. stocks prompted NASDAQ to annul trades printed at seemingly silly prices. In one of the most frenzied sessions in living memory the equity market fell victim to a combination of fear, human error and — above all — technical malfunction.

Signs of financial distress in Europe’s periphery, fiscal tightening in Asia and a likely hung parliament in the UK set a bearish tone from the open. Rumours that a fat-fingered trader then triggered a full-blown rout have yet to be proven. But whatever the starting point, it looks likely that the computerised trading — a dominant force in the modern equity market — distorted the sell-off.

One theory is that algorithms designed to respond to unusual market movements went into overdrive, in turn unleashing selling by other electronic trading mechanisms. Within minutes, every trend-following device was chasing an Armageddon trade.

This shouldn’t have happened. Electronic trading comes in many forms, but on the whole it is supposed to be good for markets. Slicing and dicing big trades into many tiny orders supposedly provides extra liquidity and smoothes away volatility. Yesterday’s gyrations suggest otherwise. The Dow Jones was down briefly by 999 points — the largest absolute move since 1987.

Checks and balances designed to stop the market free-falling don’t seem to have worked. Trading houses should have been capable of preventing any erroneous trade actually hitting the market. Exchanges should also have been able to limit the damage. After the ’87 crash, most introduced systems designed to stop markets free-falling for technical reasons. The London and New York stock exchanges, for instance, automatically switch into auction mode if individual stock prices fall by a certain amount. Such systems were apparently functioning normally at NYSE Euronext. But aggressive sell orders may simply have migrated to alternative trading platforms.

This will all be grist to the regulators’ mill. If the trading geeks want to keep their toys, they will need to demonstrate that these trader-machines are a benefit, not a hazard.

CONTEXT NEWS

– The Dow Jones Industrial Average fell by as much as 9.2 percent on the afternoon of May 6, before recovering to end the day 3.2 percent lower.

– Trading volumes soared to twice their daily average and reached their highest level since Oct. 2008. Approximately 19.1 billion shares were traded on the New York Stock Exchange, the American Stock Exchange and NASDAQ. Last year’s estimated daily average was 9.7 billion.

– The intraday decline of 999 points was the largest ever in absolute terms. It was also the largest intraday move in percentage terms since Oct. 20 1987, when the index fell 17.1 percent.

– The SEC said it would review the day’s “unusual trading activity” and that it was “working with exchanges to take appropriate steps to protect investors.”

– Citigroup said on May 6 that it had no evidence that its traders were “involved in any erroneous transaction” following rumours that it was responsible for an outsize trading order. The Chicago Mercantile Exchange said the U.S. bank’s trading activity in CME stock index futures did not “appear to be irregular or unusual”.

(Editing by Chris Hughes and Aliza Rosenbaum)

Keywords: BREAKINGVIEWS FINGER/

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