Shoot-out at the Wall Street Corral
November 13, 2010

Maria Tomchick

Mini flash crashes are proving that the US stock markets are an ungovernable mess.

On May 6, 2010, the US stock markets went into a wild plummet. Over the course of a few seconds, the stock price of several Fortune 500 companies dropped to only pennies a share while the stock of relatively unknown companies shot up to nearly a thousand dollars per share. After several minutes of chaos, human intervention finally stopped all trading on the markets. When trading resumed, prices went back to normal.

What happened? Market analysts dubbed it a “flash crash,” and the SEC spent several months studying the trades that led up to the meltdown to try and figure out what caused it. As a result, most of the major stock markets in the US (there are over a dozen now) instituted automatic circuit breakers to stop all trading in any single stock that experiences a steep and unexplained drop in price. The heads of the New York Stock Exchange and the NASDAQ reassured investors that the new circuit breakers would work and prevent another flash crash from ever happening.

This week, the New York Times reported that, since May 6th, there have been at least a dozen more mini flash crashes that have triggered the market circuit breakers. The mini crashes have involved the stock of relatively unknown companies like Progress Energy (an old-style, stable, profitable utility company) in addition to well-known mega-corporations like Citigroup, Washington Post Co., and Nucor.

A dozen mini crashes since early May means that these events are happening at the pace of at least two per month, which puts the lie to any claim that a major flash crash over the entire system couldn’t happen again. Eventually it will, if nothing is done to address the causes of market chaos.

Critics point the finger at three main causes: 1) electronic trading, 2) high frequency traders, and 3) poorly written computer algorithms. Electronic trading means that anyone, anywhere in the world can have access to the market and, with the use of a computer can set up an automatic trade. Trades occur at the speed of light, taking only microseconds to be executed. High frequency traders take advantage of the parameters of electronic trading by making a profit off the pennies or fractions of a cent that they can make on millions of lightning fast trades in any given day. Most high frequency traders enter the market every morning with their cash and completely exit the market at the end of the day owning no stock, but having amassed a tidy cash profit by gaming the system. Most of them use computer algorithms to help them buy and sell multiple stocks quickly. Poorly written computer algorithms like the one that triggered the flash crash on May 6th can lead to a crash in a single stock price, which can be magnified by the actions of other high frequency trades.

On May 6th, a trader entered a sale of a huge quantity of a single security tied to the S&P 500, but didn’t specify a minimum sale price. This made the price of the security plummet to near zero as market computers continued to try and sell the stock long after all legitimate buyers had made their purchases. Other investors, seeing a security tied to the value of the S&P 500 lose all its value, promptly panicked and sold all their holdings, which sent other stocks into a tailspin. To magnify the problem, high frequency traders, which make up the majority of trading on the markets on any given day, froze all of their trading. By withdrawing from the markets, they removed massive amounts of market liquidity; and with few buyers and no cash in the markets, the entire system crashed.

Clearly, as the subsequent mini flash crashes show, the problems still exist. The SEC has made no rules to restrict electronic trading or high frequency traders by, for example, requiring them to hold each security for a minimum amount of time. No rules exist to govern computer algorithms, either, although the SEC could and should require all traders to enter certain basic information for each trade, including minimum sales and maximum purchase prices. As the New York Times pointed out by quoting the head of the Laboratory for Financial Engineering at MIT: “The US equity markets have become the Wild, Wild West.” And the town sheriff is hiding in the saloon.

Millions of investors have pulled back or pulled out of the market since the events of May 6th, and billions of dollars have been withdrawn from US mutual funds, in spite of the current stock market upturn. This begs the question: is the current stock market upturn sustainable or is it built on wild speculation?

Meanwhile, the Federal Reserve’s policy to stimulate the economy is doomed to fail. It’s based on the assumption that if the Fed lowers long-term interest rates to boost stock prices, Americans will feel wealthy enough to spend money and the increased consumer spending will stimulate the economy. But, since the economic downturn started in 2008, fewer Americans hold stock and, if they do, flash crashes have done little to reassure them that their investments are safe, stable, or reliable.