The Wall Street Journal recently called attention to this piece of history and no one noticed. This is a serious mistake as there are lessons here pertinent to the Flash Crash of May 6, 2010.
A sharp market dislocation is not necessarily due to fragmentation or electronic market structure. Market fragmentation was nonexistent back then. Trading occurred on a physical floor. Dark liquidity referred to tickets in the pockets of floor brokers. Co-location meant an office next to the exchange. High frequency trading was defined by the speed of a conversation.
The 1962 SEC report included efforts to understand the participants involved. Surprises included the large role played by retail investors. There now is a regulatory proposal to monitor the behavior of certain classes of traders. This may be sensible. Today’s industry is not much more informed about disparate market segments. That situation deserves attention.
The role of NYSE specialists was highlighted in the report. As trading on May 28 unfolded, specialists shifted to selling. In Avco, over 85 percent of specialist sales occurred during and following the break. The IBM specialist did not intervene to slow the decline. Today’s market makers are said to have retreated on May 6. This has more to do with a human reaction to step aside when markets accelerate sharply than it does with market structure.
In 1962, 78.5 percent of public sell orders consisted of market and stop-loss orders. Recommendations included “special provisions in respect to the handling of stop sell orders or market sell orders.” Today, SEC Commissioner Elisse Walter calls for an examination of market orders. The perils of such orders are part of every curriculum in finance. Nevertheless, these order types merit another look.
The original flash crash took place as fast as that of 2010. Recommendations of the 1962 report included “temporary interruption of trading in individual securities under predefined circumstances.” Almost 50 years later, this idea has become a proposal for circuit breakers, harmonized across venues. It is about time.
May 28 revealed complex interactions, including “rational and emotional motivations.” Today, the debate concentrates on flaws in market structure, with barely a nod towards investor behavior. As the 1962 SEC staff concluded, contemplating the interaction of market pressures and personal behavior: “(these) in turn may change the impact of various normal market mechanisms, and thus temporarily impair the market’s fair and orderly character.” It is a sensible conclusion, calling for no radical changes. True fault intolerance creates rigidity, and markets require flexibility as they invariably adapt to a changing world.
The term price discovery was not in vogue in 1962, but there was extensive discussion of it nonetheless. Price discovery is the revelation of value through trading. It is a central function of markets, and is highlighted in SEC Chairman Mary Schapiro’s remarks during the June 2 SEC Roundtable. By any name, price discovery failed in 1962 and 2010.
The SEC concludes that exchange-traded funds were affected more than any other category of securities on May 6. In this case, price discovery is particularly important. A fundamental tenet of ETFs is the linkage of the price of the ETF to the price of the underlying basket of stocks.
Research suggests that price discovery for ETFs failed massively in 2010. The likely cause was a deterioration of liquidity, in absolute terms and relative to securities tracked by the ETFs. Liquidity declined abruptly to levels close to zero. Observers believe in an exit by market makers, reminiscent of the findings in 1962 with respect to specialists. There was a much broader exodus from the markets.
The popular story generated by the behavior of ETFs concerns flaws in trading market structure. The data of May 6 and the events of 1962 do not fit neatly into this tale. Market structures were wildly different, but observers saw a replay of a vintage film on May 6, right down to the timing. More important is the contrast between investor behaviors---there was none. Liquidity was not supplied by participants and sell orders ripped through the market. Price discovery was destroyed by the lack of liquidity, which led to a downward spiral as confidence dissipated. Investors supply liquidity. Exchanges and alternative trading systems do not.
True flash crashes are rare events. Market structure changes, and although people adapt, fundamental behaviors may not. Sometimes, bad things happen to good markets.
Ian Domowitz is the Managing Director at Investment Technology Group Inc.