SEC Aims to Prevent Another 'Flash Crash,' With a Partial Solution

The SEC is investigating the causes of the May 6
The SEC is investigating the causes of the May 6

Washington is finely attuned to the public expectation that it needs to do something about the May 6 "flash crash" -- when the Dow fell almost 1,000 points within about 15 minutes, and then bounced back to end the session down by only 300 points. But the difficult question facing lawmakers is how they can balance their need for campaign cash against the interests of most voters.

It's been five weeks and no one cause has been identified. The most likely explanation is that so-called high-frequency traders, needing to keep a balanced book -- the number of sell orders must equal the number of buys -- decided to stop trading because their order books had become too imbalanced.

Will the SEC Level the Playing Field for Retail Investors?

The Securities and Exchange Commission hasn't found the cause of the flash crash, but it's putting in circuit breakers to prevent a recurrence. The Washington Post reports that the SEC will stop for 5 minutes the trades of any stock that goes up or down by 10% within 5 minutes. These circuit breakers apply to S&P 500 stocks, but not to more sophisticated financial instruments. They'll go into effect Friday on the New York Stock Exchange and Monday on the Nasdaq and other exchanges, according to the Post.

SEC is also talking about leveling the playing field between high-frequency traders (HFTs) and retail investors. High-frequency traders control 70% of daily trading volume, and they generate risk-free profits by taking advantage of 100-millisecond timing advantages over retail investors -- using price and order information just before it hits exchanges to trade ahead of retail investors.

To fix this problem, the SEC "is considering rules governing the practice to ensure that it is offered to all comers in a nondiscriminatory way," according to The New York Times. The SEC is also considering rules that would keep so-called dark pools -- privately owned trading exchanges that permit market participants to place anonymous buy and sell orders without revealing prices -- from taking advantage of what SEC Chair Mary Schapiro called "lit markets."

A $4.8 Billion Shudder Through the HFT Ecosystem

How would the SEC level the playing field? According to Sal Arnuk, a Partner of Themis Trading LLC, a trading firm, the SEC might do this by slowing down the speed of high-frequency trades so they get executed at the same time as those of the so-called standard information processors that serve the retail investor.

The SEC's comment is striking fear into the hearts of the high-frequency traders. As Sarnuk says in an interview, "This is huge!" Schapiro's remarks "are sending shudders down the spines of the NYSE that runs a co-location facility in Mahwah, N.J., and the high-frequency traders at [hedge fund] Citadel, [electronic trading firm] Getco and the major investment banks like Credit Suisse."

The source of that fear is lost profits. Schapiro's proposal could slash $1.8 billion in co-location fees that high-frequency traders pay exchanges like the NYSE to put their computers next to those of the exchanges. And there's the $3 billion in estimated profit that high-frequency traders make through the practice of latency arbitrage, where they get prices a fraction of a second before the retail investor.

Some Benefit to Retail Investors

High-frequency traders do provide some benefit to the retail investor. Arnuk points out that they make it possible for retail investors to pay just $8 for a trade and to pay narrower spreads between bid and ask prices. But he also believes that latency arbitrage in some cases makes those retail investors pay between 4 cents and 8 cents more than they would otherwise.

Arnuk thinks the SEC should end the guesswork about how much latency arbitrage costs by requiring trades made by high-frequency traders to be tagged. This means that the letter H would be appended to the information on high-frequency trades along with the usual details of time, date, price, quantity and trading symbol. This tagging would enable the SEC to measure the cost to retail traders of high-frequency trades.

The circuit breakers are a good start. However, according to Arnuk, those won't prevent the next flash crash unless the SEC coordinates the different exchanges to make sure that they all use the same circuit-breaking procedures. Without such central coordination, there is a risk of a recurrence of market dislocation.

Campaign Contributions vs. Calming Voter Anger

Wall Street isn't alone among industries that funnel money to government officials. The financial services industry gives $500 million a year to Washington politicians and lobbyists. It remains to be seen how much Washington will crimp those contributors' profits to protect the interests of the vast majority of American citizens.

While we all can vote, it may be that voters who give money to Washington have a louder voice than those who don't.