Flash Crash Causes $200 Million in Losses, Circuit Breakers Need Fixing

Monday, September 13, 2010

New York Stock ExchangeThe flash crash on May 6th exposed serious structural flaws in today's equity markets. The Dow Jones Industrial Average dropped more than 600 points in just a few minutes almost reaching down 1,000 points on the session before dramatically rebounding. Major Dow component, Procter & Gamble (PG), collapsed over 30% in minutes while Accenture (ACN) saw its share price literally drop to one penny. A shocking "324 securities suffered price moves of more than 60 percent from their 2:40 PM prices leading to the exchanges cancelling more than 20,000 trades". Financial market participants will not soon forget the afternoon of May 6th.

Arguably the greatest amount of damage from the event was inflicted on investor confidence in the stability of the equity markets. Since May 6th, equity mutual funds have seen outflows of funds now totaling over $60 billion. While worries about European sovereign debts and a slowdown in the US have been clear factors motivating selling, the flash crash worked to exacerbate investor fears.

On top of the loss in confidence, many investors believing they were being prudent actually lost money by having their stop losses triggered in the wild gyrations. "A staggering total of more than $2 billion in individual investor stop loss orders is estimated to have been triggered during the half hour" resulting in, based on "a very conservative estimate of 10 percent less than the closing price", "losses of more than $200 million".

The SEC's quick response was to institute circuit breakers on stocks to prevent the event from occurring again in the future. Any stock that trades 10% above or below the prices over the previous five minutes will be halted for five minutes. The goal is to aid price discovery by allowing the market five minutes to come to a consensus of the correct price.

Yet, as soon as this rule was adopted we began finding problems with false halts because of anomalous prints. In late June, Citigroup (C) was halted from an out-of-market print while late July saw the same in Cisco (CSCO). These stocks trade millions and millions of shares a day and should not fall victim to a poorly designed system.

Clearly, this problem must be studied and changed. The simplest solution, in my mind, is to make circuit breaks trigger ONLY with two consecutive prints greater than 10%. This seemingly avoids the current problems yet maintains the intended stability in prices.

"Strengthening Our Equity Market Structure"
SEC Chairman Mary L. Schapiro
September 7, 2010

Brandon R. Rowley
"Chance favors the prepared mind."

*DISCLOSURE: Nothing relevant.
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