Eng Final Report

8/8/2019 Eng Final Report

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_____________________________________________________________________________

Proposal for Reform: Rules and Regulations

to protect electronic exchanges from

experiencing technical failures similar to

those occurring on

May 6, 2010.

Bloomberg Research Journal

100 F Street, NE

Washington, DC 20549

Jason KirschMiami UniversityFarmer School of Business

December 2010


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ABSTRACT

This report evaluates the May 6, 2010 flash crash and details preventative actions that

should be considered immediately. Further study into the matter targets high frequency

computerized trading programs as the main culprit. The underlying assumption of my proposal

is that greater control of market prices can be attained by transferring power from computers to

humans. Holding this assumption, the report pitches six reforms that should be administered

immediately. Each proposed reform has been developed to meet specific criteria in that the

alteration must provide clear benefits that must include enhanced transparency while not hurting

liquidity.

The transfer of power from high frequency trading systems to human traders will lead toward

a shift from unidentifiable back end costs to slightly higher front end costs. Further analysis lead

toward six major preventative measures that meet the necessary criteria. They are as follows.

1. Adding a three second pause before trade execution would ban the process of quotestuffing and allow more transparent price quotes for securities.

2. Installing circuit breaker systems on major and private exchanges would prevent bigdrops in prices by pausing market trades if the price of a security fell more than 10% in a

15 minute span.

3. Enforcing a maximum spread less than or equal to 50 basis points will increasetransparency and limit the momentum of price movement in down markets.

4. Enforcing stricter short-sell rules would limit the incentive for traders to put downwardpressure on prices because they would not be able earn a great profit on the fall of prices.

5. Cutting taxes for major exchanges that promote non-computerized trading will reduceincentive for exchanges to push computerized trading in which they earn greater profit

from high volume of trades.

6. Creating an audit trail for institutional traders might prevent harmful trades by greaterlaw enforcement.

Intensive research enforces powerful arguments in favor of each reform mentioned in the

report. Further explanation on the benefits and costs of each reform can be found in the body of

the report. These reforms should provide necessary measures to prevent events similar to those

occurring on May 6, 2010. With strict enforcement, markets should experience more favorable

conditions.


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CONTENTS

1. INTRODUCTION TOTHE EVENTS ON MAY 6, 2010Pg. 42. CAUSES OF FLASH CRASH Pg. 5-63.RULES AND REGULATIO NS Pg. 6-94. CONCLUSIONPg. 10

A.SUMMARY CHARTPg. 11B.BILIOGRAPHY Pg. 12C.GLOSSERY Pg.13


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INTRODUCTION TO THE EVENTS ON MAY 6, 2010

Earlier this year, a monumental event tested the adhesiveness ofAmericas financial

engine, Wall Street. The Dow Jones Industrial Average dropped nearly one thousand points

within a one hour time frame. Hundreds of stocks lost more than sixty percent of their value

while investors sat powerless on the sidelines. As financial professionals realized they had lost

control, flight or fight mode took over. Confusion was the only barrier to total chaos. By the end

of the trading day, the market regained most of its losses while talking heads were already

starting to lay blame. Investors all over the world sat in high anticipation of the Securities and

Exchange Commissions actions.

Exhibit 1

Five months later, the SEC released a well-crafted report with intent to restore

confidence. While mainly focusing on causes of the crash, their goal was not accomplished.

Instead the lengthyreport created more uncertainty among investors, causing the public to lose

faith in the SEC. Many argued if the SEC would ever strive to prevent an event like this in the

future. Desperate for reform, congressmen all over the nation started to argue for major changes

to system. Currently not much has changed to theAmerican financial system. An event similar

to the May 6, 2010 Flash Crash could occur at any moment.

Today, action is needed to prevent future technical failures in our markets. Another

market wide panic can not only slow economic growth but has a high possibility of sending

America into a depression. By adopting the six reforms mentioned in the body of the report, the

SEC will be stepping in the right direction, the road leading to a stronger economy.

The Chart to the right

shows the price of the Dow

Jones Industrial Average

over the market hours of

May 6, 2010

Source:Yahoo Finance

05/06/2010

www.Finance.Yahoo.com/F

lashCrash


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CAUSES OF THE FLASH CRASH

The market setting on the morning of May 6th was filled with worried traders. Investors

were in panic over the sovereign debt crisis sweeping over Europe that led to deterioration of

investors previous gains. Because of high uncertainty, institutions were pressuring traders to bepatient while working under strict caution. Intense fear pushed investors to sit on the sidelines

while traders found their job to be more difficult due to extremely low volume. The market was

waiting to pounce on the next event, whether good or bad.

Exhibit 2

The official report laid blame on a single trading firm, labeling them the spark of the

crash. The SEC outlined the scenario where a firm in Chicago executed a large directional trade

based upon an attempt to profit from a market mispricing. The unordinary scale of volume

tricked automatic computer trading programs to place large sell orders, putting downwardpressure on market prices. The players responsible for filling these trades used automatic trading

programs as well. Before human traders could do anything, market prices were already at

bottom. Stocks of corporations such as Proctor and Gamble, Boston Beer and Nordstrom

dropped to pennies per share before recovering. Realizations that the drop in prices could not

reflect true value sent the prices back near normal. Because capital markets are interconnected,

the changes in stock prices cause changes in market prices of non-stock assets. For example, the

change in the S&P500 index sparked a more volatile exchange rate between the U.S. Dollar and

the Euro (shown in the Exhibit 3). At the end of the trading day, the SEC released news stating

they will restore positions on stocks affected by the crash to pre-crash levels.

The chart to the left shows

volume of the Dow Jones

during the Day of the flash

crash. Notice how the volu

(shown in teal) is much low

that morning and then spik

up. Volume

Source:Bloomberg; 05/06/2010 www.Bloomberg.


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Exhibit 3

After much argument, the financial industry began to accept that high frequency

computerized trading was the primary reason why the markets lost control. These systems makedecisions based on specific variables faster than humans could realize what has occurred. While

these programs generated higher profits for firms and lower upfront transaction costs they also

led to dangerous unidentifiable back end costs. These back end costs, since unidentifiable and

unexpected are more toxic to markets.

Exhibit 4

However measures taken to prevent another technical crash do not need to include a ban

of high frequency trading systems. Restrictions on how these systems are used offer enoughsafety while greatly saving the benefits. Two hazardous operations done via high frequency

trading systems are Quote Stuffing and Stub Quoting. Quote stuffing is a common

procedure by proprietary trading firms that use high frequency trading algorithms to send out a a

large volume of bids only to retract them immediately after. These bids usually give false

signals to investors on price direction. For example, if a firm sends out a large amount of buys

above the market price, investors see that other investors would pay more money for the security.

The chart to the left represen

the change in the Euro to Doll

exchange rate during the pea

15 minutes in which the flashcrash occurred. This

demonstrates the level of

interconnection among the

stock market and the currenc

market.

To the left is an image of a single

control desk for a High Frequency

Trading System. Not shown is theserver room, which can take up

anywhere from 100 square feet to 80

square feet.

Source:motleyfoot.com; 05/06/2010 www.motleyfootl.com


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Quote stuffing leads to traders devaluing trends in prices. If a trader values these trends, they

might be able to execute a sell order at a higher price. Stub quoting is a method used by market

makers, who are parties that provide liquidity to markets for other governmental benefits. A

market maker is required to provide a quote above and below the market price in that they have

to fill either a buy or sell order. A stub quote is a place holder quote used by market makers that

is far from the market price. Their purpose is to fulfill their obligation, while making it unlikely

to execute the trade. By doing this market makers can bet on the direction of the market o profit

greater. Many traders do not see this as a negative because a greater profit increases market

maker competition and reduces transaction costs of trading. On May 6th, lower stub quotes were

filled before market makers could replace them. This gave momentum to the downward spiral of

prices. While providing benefit, unregulated use of computerized trading algorithms only creates

hazardous unidentifiable costs to investors.

RULES AND REGULATIONS

Global markets can benefit by stronger regulation of high frequency trading systems and

electronic exchanges. By transferring power from computers to humans and preventing

unordinary swings in market prices, markets will become less volatile, safer and more trusted by

investors. Following, I propose six reforms that clearly hold this assumption. All proposed

changes meet specific criteria in that the alteration must provide clear benefits that must include

enhanced transparency while not hurting liquidity.

Reform #1: Instating a mandatory clearing period of three seconds before trade retraction on

electronic exchanges.

One of the major functional reforms the market needs is a restriction on the act of

quote stuffing. By instating a three second period before allowing bid retraction, high

frequency operators will not be able to quickly retract their bids, and the trades can be

executed. The risk posed of possible execution should prevent the majority of quote

stuffing by firms who operate high frequency trading systems. Three seconds will not do

any harm to liquidity because the markets will always be three seconds delayed. Having

a clearing period will also prevent other types of market price manipulation that have to

do with false trade quotes. Since only electronic exchanges pose a problem, installing

this clearing service would be a low cost initiative.

Reform #2: Install and maintain circuit breaker systems on major and private exchanges.

Circuit breakers on electronic exchanges are necessary in damage control. The breakers

will stop trading on securities after certain criteria are met. After ten seconds, trading will


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resume again but follow the same restrictions. The system is considered an option of last

resort that wont stop a crash but will minimize damage and create more investor confidence.

Traders will be able to tell when a circuit breaker is triggered by signs in the market price.

Different criteria apply to different securities to keep up with natural volatilities.

1. Stocks priced $25 or less:Breaks if the trades are 10 percent away from the circuitbreaker trigger price.

2. Stocks priced $25 to $50:Breaks after 5 percent swing from the circuit breaker triggerprice.

3. Stocks priced $50 or greater: Breaks after 3 percent swing from the circuit breakertrigger price.

Circuit breakers serve our purpose as a band aid instead of a preventative measure.

History has shown that we should take advanced precaution no matter upon the

circumstance.With time certain market conditions might arise where circuit breakers will

prove of use.T

he cost to implement is next to nothing and possible side effects are of nosubstance.

Exhibit 5

Reform #3: Pose a maximum spread of 50 basis points on market makers Bid-Ask price quotes.

Aside from quote stuffing, stub quoting is a major hazard of high frequency

trading systems. Controlling market makers to place quotes within a certain price

interval will provide buy and sell prices that reflects true market price and therefore

increase liquidity. While creating more liquidity, markets will become less volatile

because quotes that are not meant to be filled wont be automatically filled by computers

and prices will fluctuate naturally. This reform could be done as easy as a signature.

There were circuit breakers in place during

the Flash Crash . However these circuit

breakers were not strict. The chart to the left

shows the amount of high frequency trades

that were blocked compared to the trades that

were executed.

Source:Bigcharts.com 05/06/2010

www.Bigcharts.com


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Since market makers only receive benefits if they accomplish their responsibility they

will have incentive to follow the regulation. However this regulation will lower profits

by these liquidity providing firms. By heavily regulating this change, natural and

effective competition will increase and firms specializing in market making will need to

innovate to succeed. Over time upfront prices will be as low as before.

Reform # 4: Ban the act of Short Selling.

Short selling is the process where an investor sells a security without actually

owning the security. The investor is given the ability to short sell by brokers allowing the

investor to borrow the security from another investor, with terms to return the same

security in the future. Investors profit on short selling by selling the borrowed security at

a higher price than they return it at. Short selling creates more volatile markets because it

allows investors to profit quickly on falling prices. By selling securities that would not

normally be sold, great downward pressure is put on market prices. Short selling gives

investors great incentive to push market prices downward. This almost always leads to adownward spiral effect when there is a drop in market prices.

By banning short selling the government would not ban ways to profit on

downward markets. However to accomplish this feat, the investor would have to execute

more timely trades that would have much less of an impact on volatility.

Reform #5: Cut Federal taxes for exchanges that do not allow high frequency trading systems.

Many experts believe that banning all use of high frequency trading would cause

great short term damage to the economy. Currently, our economy is not strong enough to

handle such a drastic change. However, providing incentives to electronic exchanges to

control the use of high frequency systems can slowly reduce global reliance. Cutting

federal taxes for exchanges that do not allow, or disapprove use of high frequency

computerized systems can jumpstart a major trend in the market. Exchanges will have

enough incentive to begin to promote the shift in power from computers to humans.

While our economies health does not currently rely on this transition, it can offer

great benefits in the future. The slow transition would not harm liquidity while it would

make markets more efficient and transparent. Human traders will be forced to survive by

developing innovative practices that do not use automated systems. Over time our

markets will become more efficient and much less risky.

Reform #6: Impose a mandatory Audit trail for all institutional traders who manage over five

million U.S. dollars of capital.

One reason for unorthodox and sometimes unethical market practices is weak

enforcement by the Securities and Exchange Commission. More stern enforcement will


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provide more risk of consequence for unethical and unorthodox behaviors. Since the

SEC has fixed resources, the most cost effective way to enforce market practices is

through audits. By implying mandatory auditing for institutional traders, traders are less

likely to take selfish action that might hurt the markets. Aside from discovering fraud

and unethical practices, the SEC can use this as a way to further learn how Wall Street

functions. Auditing institutional activity will also provide more business for accountants

by expanding the area their service covers. The cost is cheap, the downside is limited and

the benefits are great.

CONCLUSION

Nobel Prize winning economist Paul Krugman once said Greater use of computers has

propelled the growth of our economy while greater reliance will ignite its downfall . It is now

clear that the market crash on May 6th, 2010 was caused primarily by reliance on computerized

trading. Regulation of these computer systems is the best way to control markets to make them

more efficient.

The six reforms previously outlined can jumpstart the transition into a better controlled

market. While each change has individual benefits, together they should create market

synergies. Theyprovide necessary measures to prevent technical failures so our markets do not

experience a more devastating Flash Crash. Together, these reforms should create a more

liquid, transparent and effective market. With strict enforcement, markets should experiencemore favorable conditions.

The May 6th Flash Crash was a major warning that computerized operations should not be

relied on. Experts already know, in theory, the science behind the fastest possible computer.

When humans reach that point, a long lasting depression might be in store. While instantly

demolishing computerized trading systems would send our economy into frenzy, promoting a

change away from computer reliance will without doubt benefit global markets. More individual

power has the potential to evolve the lines of human competition from who can create the

smarter computer to who can control it.


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Reform Description Benefits

Instating a mandatory

clearing period of threeseconds before traderetraction on electronicexchanges.

A threesecondclearing period

willincrease transparencywhileminimizing quotestuffing

activities. Theclearing period

prevent intentional

cancellationsand willimprove

liquidityconditions.

Minimizationoftheact ofQuote Stuffing

Reduces VolatilityLow Cost

Givemore power toindividualinvestor

Install and maintaincircuit breaker systems onmajor and privateexchanges

Circuit breakers willact asaact

oflast resort. Theyareasafety

net, capableofstopping

maniasand panicsandare

usefulincreatingconfidence

amonginvestors.

Provides Damage Control

Reduces Volatility

Raiseinvestor Confidence

Pose a maximum spreadof 50 basis points onmarket makers Bid-Askprice quotes.

A maximumspread will

increasecompetitionamong

market makersand therefore

increaseliquidity. A maximum

spreadalsoeliminatesstub

quotingandreducesvolatility.

Minimize Stub Quotingby Market Makers.

Increased Liqudity

Low Cost

Reduces Volatility

Promote Natural Market Cycles

Greater Transparency

Ban the act of ShortSelling.

Eliminatingshort selling will

most important create

incentiveforupward pressure

onstock price. Thisleads to

greaterinvestment profit,

government taxrevenueand

growth. It willminimize

unethicaldecisionmakingand

transparency.

Reduces Volatility

Createsmoreopportunitiesforinvestment

Reducesunethical pricemanipulation

Increasesincentiveforstock pricegrowth that

canlead togreaterinvestment.

Will Increase Transparency

Cut Federal taxes forexchanges that do notallow high frequencytrading systems.

A taxcut forelectronic

exchanges willcreateincentive

for them tomove towards

human trading. It willcause

greatercompetitionand

identifiableandlowerlong

term transactioncosts.

Providesincentive tobegin the transitionof

powerfromcomputerizedsystems to

professionals.

Canlead tofuturebenefits

Lead towardamorecompetitive Market


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Sources for Research

All-In-One Source

"Flash Crash."Wikipedia.Web. 19 Oct. 2010. .

Explanations of Events that Occurred on May 6, 2010Bommarito, Michael. "SPY Flash Crash Summary."Seeking Alpha: Bommarito (2010). Web.19 Oct. 2010. .

Caldwaller, Amy. "Data Wonks Debut Dizzying Diagram of Flash Crash."WallStreet Journal27 Sept. 2010. Print.

Caldwaller, Amy. "Dow Takes Harrowing 1,014.14 Point Trip."WallStreet Journal06 Aug.2010. Print.

Durden, Tyler. "SPY Flash Crash: NYSE Cancels Trades."Zero-Hedge.com. Zero Hedge (TylerDurden). Web. 19 Oct. 2010. .

"Econobrowser:Causes of Flash Crash." Econobrowster. 02 Oct. 2010. Web. 19 Oct.2010. .

Zeiger, Timothy. "SEC Probes Cancelled Trades."WallStreet Journal27 Sept. 2010. Print.

Factors that might of caused the Flash Crash

Mason, Christopher. "Investors, Regulators Laid Path to Flash Crash."WallStreet Journal29Sept. 2010. Print.

Regan, Michael. "NYSE Software Glitch Spurs $7.9 Billion Misprice in S&P 500 ETF." Bloomberg.com. Web. 19 Oct. 2010. .

Future Regulations to Prevent Similar EventsPatterson, Scott. "Legacy of Flash Crash: Enduring Worries ofRepeat."WallStreet Journal06

Aug. 2010. Print.Pewter, Maria. "Limit System May Replace Circuit Breakers."WallStreet Journal24 Sept.

2010. Print.Ratner, Hank. "SEC Urged to Tighten Market-MakerRules."WallStreet Journal12 Aug. 2010.

Print.Youngei, Rachel. "SEC Brushes Off Flash Crash Report Critics."Reuters.com.

Impose a mandatoryAudit trail for allinstitutional traders whomanage over five millionU.S. dollars of capital.

Auditinginstitutional traders

will prevent unethical

behavior. Thegovernment will

alsobetterunderstandinsider

practices tobeable toregulate

moreefficiently.

Minimizeunorthodoxandunethical practice.

Promotesmoreinvestment byindividuals.

Increases Liquidity

Creates Revenue

Leads to Greaterunderstandingandinformation

sharing.

Limited Downsideand Low Cost

Summary of Reforms


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Thompson Reuters.Web. 19 Oct. 2010. .

Official Documents

"SEC Official Market Report for Events on May 6, 2010."SECOfficial Website. SEC, 2 Oct.

2010. Web. .

Glossary Terms

Audit the evaluation of a person, organization or process in order to make sure specifics are in

line.

Bid- Ask Spread The difference between the price that a market maker buys a security and the

price that they sell that same security.

Circuit breaker an automatic switch designed to pause market activity when an abundant

amount of volume is being generated.

Dow Jones Industrial Average A widely used stock index that represents thirty of the largest

corporations.Is used by investors to represent the change in value of larger stocks.

Electronic exchange A non physical location where people buy and sell securities. This is

usually dont over complex computer systems.

Liquidity The ability to sell an asset at market value relatively quickly.

Market maker Traders who receive benefits from exchanges to provide a quote to buyers and

sellers in order to create liquidity.

Points an indicator representing the price of a group of securities.

Quote stuffing A technique whereby large volume of trades are placed before being

immediately cancelled. Quote stuffing is mainly used by institutional investors that want to send

false signals.

Security A claim to an asset that is traded through an exchange or between two parties.

Stub quotes an order at a price far from the current market price. Stub quotes are used by

market makers to fulfill their responsibility while giving them the ability to bet on the direction

of the price.


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Transparency the ability for individual investors to receive the same information as the rest of

the market.

Volatility Amount of deviation from the market price throughout a time period.