What the Heck Happened Last Week?

05/10/2010 10:26 am EST

Focus: MARKETS

Terry Savage

Author, The Savage Truth on Money

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 (CME) 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.

Before we go any further, I need to disclose that I am a director of CME Group (Nasdaq: CME)— 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 early Friday morning, saying that both its floor and electronic markets functioned without anomaly, and its clearing house performed flawlessly.

So far, the Securities and Exchange Commission and Commodities Futures Trading Commission have not announced any conclusions about how the event started. But many traders report that prices fell precipitously in several stocks, with the most noticeable being Proctor and Gamble (NYSE: PG), a relatively staid stock that is a part of the Dow Jones Industrial Average. Its sudden 30% drop was immediately reflected in the DJIA calculations—calling widespread attention to the anomaly.

While stocks and indices rebounded within the hour, the market tsunami left both losses and questions in its wake. The New York Stock Exchange 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%. No futures trades on the indexes were cancelled. 

But someone was on the buy side of all those low-priced trades. Many quickly sold at a profit when the market rebounded. If the purchase is cancelled, they are effectively left short the stock they subsequently sold. You can be sure that a lot of traders were sweating it out over the weekend.

And 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 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 only about 90 seconds to assess whether these trades were “for real.” During those few seconds, orders were automatically transferred to smaller electronic stock exchanges, hitting the stops in these thinly traded markets and pushing prices down to pennies a share in the case of one stock, Accenture (NYSE: ACN), which fell from $40 to one cent!

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 (or during the recent financial panic). It demonstrated that even professional “specialists” can become paralyzed with fear and stop making markets.

No, I think a better solution is to require electronic markets to have a “fail safe” provision in their order systems, requiring 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 these small electronic market makers. Sound familiar?

Just as you can’t move back to the “horse and buggy” days because of a braking system flaw in today’s automobiles, you can’t move back to the “human hands and chalkboard” system because a small, but significant, part of the current system suffered a failure.

So, let’s fix electronic trading, but don’t throw it out. What do you think?

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