Hunting the Flash Crash’s Cause, and a Fix

More than two weeks after the May 6 “Flash Crash”, it’s still not clear what caused that 700 point drop in the stock market. Regulators now say the  whole story may never come out.

In retrospect, there was something comforting in the early “fat finger” explanations. Though unsettling to think the New York Stock Exchange could drop hundreds of points because of a typo, it’s at least possible to picture a trader accidentally typing a ‘b’ for billion instead of an ‘m’ for million. A simple software patch could prevent that from repeating. But as the weeks grind on since the 6th, the circumstances of that frightening Thursday tumble grow more difficult to pin down and thus less simply fixed.

On May 24, Reuters reported that CFTC Commissioners Jill Sommers and  Michael Dunn both say a total understanding may never arrive.  “The real question is, are we going to be able to institute regulations, structural organization that ensure we don’t have this type of meltdown or we have steps to keep it from happening,” Dunn told Reuters.

How do you come up with a solution for a problem you don’t fully understand?

Peter J. Henning, a professor at the Wayne State University Law School who also writes for the New York Times,  reports that the SEC’s  enforcement division will face some limits in its attempt to hold the responsible parties to task. The SEC oversees registered broker-dealer firms that act as market makers.  Traditional market makers must stand in and take the other side of a trade when there is no other party to do so.  That keeps the market liquid. But over the years, proprietary firms have taken to informally providing liquidity to the markets in a similar fashion. The difference: they don’t have to stay in the sandbox when the game turns ugly. And  their actions are not the subject of SEC enforcement. On May 6, they may well have stepped out. Here’s Henning’s description:

Unlike a broker-dealer firm, which is registered with the S.E.C. and must abide by certain rules that require it to maintain trading in securities, the proprietary firms can simply leave the market whenever they wish. Thus, there is a mix of regulated and unregulated entities that undergird the liquidity in the market, which may have contributed to the market volatility when they did not continue to supply liquidity to the market.

Henning goes on to explain the legal status and responsibilities of these proprietary firms — and more importantly what they are not responsible for. Putting this informal market making under the SEC’s purvue, for example,  would require new regulation. Such rules, Henning notes, could well cause these parties to exit the practice all together.

Even if regulators are able to piece together a reasonable picture of  what happened in that brief stretch of afternoon May 6,  they may find those problems very hard to fix.

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