High-tech solutions needed to avert panic
BY TERRY SAVAGE May 10, 2010
Trader Steven Rickard reacts in the S&P 500 futures pit at the CME Group in Chicago near the close of trading Thursday -- a day when the Dow briefly dropped by nearly 1,000 points.
Updated: May 3, 2013 12:14PM
Last week's market "glitch" was shocking to behold in real time. As it happened, I was in the boardroom of the Chicago Mercantile Exchange when the slide started. The huge room is equipped with screens that can be viewed from every seat around the table, and all eyes turned to the screens as the numbers changed quickly in red.
(Full disclosure: I am a director of CME Group -- but my commentaries do not speak for the company and I have no non-public information on what caused Thursday's strange events. CME Group issued a statement Friday morning, saying that both its floor and electronic markets functioned without anomaly, and its clearing house performed flawlessly. The New York Stock Exchange and Nasdaq issued similar reports.)
So far, the Securities and Exchange Commission and the Commodity Futures Trading Commission have not announced any conclusions on how the event started. But many traders report that prices fell precipitously in several stocks, with the most noticeable being Proctor & Gamble, a relatively staid stock that is one of the 30 that make up the Dow Jones industrial average. Its sudden 30 percent drop was immediately reflected in the DJIA calculations -- calling widespread attention to the anomaly.
The cascade of selling triggered "stops" -- orders to sell -- which had been placed below then-current trading levels. When prices fell, those stop orders became market orders, adding to the selling pressure.
While stocks and indices rebounded within the hour, the market tsunami left both losses and questions in its wake. The NYSE and Nasdaq announced that they would bust trades made during a 20-minute period of the most extreme volatility, in cases where the losses were more than 60 percent. No futures trades on the indices were canceled.
Will we ever know why it happened in the first place? The "fat finger" theory just doesn't work in practice. The fanciful idea that someone hit "billions" instead of millions fails because there is no keystroke for billions. But it could be that one order was punched repeatedly, or that zeroes were inadvertently added to the number of shares in a sell order. That seems more likely because the drop hit just a few stocks at first.
It's not beyond possibility that some malicious hackers got into the system, perhaps as a test -- or as a warning. But no one has taken blame. And there's no explanation as to why the market suddenly rebounded instead of continuing to the downside.
What is certain is that as the wave retreated, it exposed the faults in an intricate network of electronic trading. Most investors think their stock orders are executed on the NYSE or Nasdaq, unaware that orders in shares listed on those exchanges are routed electronically to get the "best price" available on any electronic exchange.
When the cascade started, the NYSE floor immediately declared a "pause" of about 90 seconds to assess whether these trades were "for real." During those few seconds, orders were automatically directed to smaller electronic stock exchanges, which were still posting bids. The sales pushed prices downward, hitting the stops in these thinly traded markets. Some stock prices dropped to pennies a share, as in the case of Accenture, which fell from $40 to 1 cent! Similarly impacted were shares of 295 other companies, including Exelon, Google and Apple.
Now the debate will rage: Can you trust electronic exchanges or do you need the "human touch" to provide guidance in extreme market events?
Obviously, those who think that mere humans will provide rational calm in times of distress have forgotten what happened in 1987 during that stock market crash. That crisis demonstrated that even professional "specialists" can become paralyzed with fear and stop making markets.
No, I think a better solution is to require all electronic markets to have a "failsafe" provision in their order systems -- instituting a trading halt based on common parameters.
The electronic systems didn't make a mistake. That mistake was made by the people who designed them. And by the regulators who did not recognize the danger inherent in small electronic market-makers that post bids for only a small number of shares.
Just as you can't move back to the horse and buggy days because of a braking system flaw in automobiles, you can't move back to the "human hands and chalkboard" system because a small, but significant, part of the system suffered a failure.
The good news is that because all of this trading was handled electronically, the SEC and CFTC will certainly be able to eventually uncover the cause. It's not so certain that they will be willing to reveal the cause. But for our financial markets to regain the public trust, we need to understand both the problem, and what is being done to fix it. That's The Savage Truth.
Terry Savage is a registered investment adviser and a co-host of ''Monsters and Money in the Morning'' on WBBM-Channel 2 from 5 to 7 a.m. weekdays.