Reflections on the Real Implications of the Flash Crash

It’s been about seven weeks since the “Flash Crash”, in which $1 trillion of the value of American public companies evaporated in about one half hour. Although the Dow recovered more than 600 of its 1000 point drop by the end of the day, it was unnerving to observe. It was clear that for at least a while something very dangerous was happening over which no one had any control.

Initial explanations for the crash ranged from implausible to downright silly. For several days, the rumor was that a trader had pressed the wrong button, initiating a sale of billions, rather than millions, of shares to be sold. This explanation ignored the basic risk controls that are built into virtually all trading systems at major investment firms. Absent an official explanation, however, traders and investors were left to speculate what really happened.

More recently, progress has been made towards understanding the cause of the breathtaking market decline. It now appears that the so-called “flash traders” which account for a very large percentage of the trading volume each day on the stock exchanges simply declined to trade electronically. Absent the market makers who used to inhabit the exchange floors and whose job it was to maintain an orderly market, prices went into a free fall as market liquidity vanished. However, this explanation is not yet official and may turn out to be only a part of the cause.

The Securities and Exchange Commission has already put rules in place to mitigate the risk of a repeat performance. SEC Chairman Mary Schapiro announced last week rules that would suspend trading of any stock in the Standard & Poor’s 500 index that rises or falls 10 percent or more in a five-minute period. “By establishing a set of circuit breakers that uniformly pauses trading in a given security across all venues, these new rules will ensure that all markets pause simultaneously and provide time for buyers and sellers to trade at rational price,” she indicated.

Perhaps. This strikes us as a measure designed to relieve the symptoms without curing the disease. Many commentators have charged that regulators are woefully behind the technology curve. We agree – they don’t have the resources to counter the massive investment that companies ranging from tech-savvy trading shops to Goldman Sachs have committed to, for instance, the instantaneous algorhythmic transactions that now comprise so much of each day’s volume.

Regulation is anathema to the Street. Many in the investment community see the regulatory authorities as hindrances to business and market efficiency, and there’s a lot of anecdotal evidence to support that perspective. But the financial community has pushed the envelope in the last few years, culminating in the near collapse of the system in October, 2008. While Wall Street may regard the various regulatory authorities as the greatest threat to business as usual, there is a bigger issue.

The public perception of the behavior of financial professionals is at an ebb right now, ranging from the anger over the compensation packages of executives that appear to be disconnected from their actual performance, to surprise over the number of private money managers who have treated their clients’ funds as their own ATM. The need for faith in the system on the part of investors is a common cliché, but it may be time to give it an injection of substance. Otherwise, with an administration that is clearly willing to harness populist energy, public anger over the behavior of the financial community may eventually result in a wave of regulation exceeding anything we’ve seen before.

The Flash Crash may represent an opportunity for financial professionals to reconnect with their responsibilities to the public. Here’s our four part plan:

(1) get to the bottom of the flash crash and put in place price discovery mechanisms that eliminate the ability of traders with the fastest computers to game the system;

(2) Congress should pass a real financial regulatory reform bill – we’re in favor of Glass Steagall, the uptick rule, fiduciary standards for brokers, stringent capital requirements/strict leverage limits, banning the originate and distribute model, requiring all derivatives to be settled through a national clearing house, to name a few good ideas;

(3) beef up the expertise of the regulators – all of the current discussion centers around turf rather than capability – so that they can keep up with innovation rather than lagging badly; and

(4) move to international accounting standards and away from the constant shifting of U.S. accounting standards.

For Wall Street, American investors may be a captive audience. They do not have the attention of financial executives, but they do have the ability to influence the behavior of their legislators. If the leaders of the financial industry do not demonstrate a willingness to act on behalf of investors, they may face a wave of regulation that will dramatically constrain their activities. In that case, they would be getting what they deserve.

We believe the banks and brokers would be better off following the model of the mutual fund industry, which has long embraced a comprehensive set of regulations designed to eliminate fraud and conflicts of interest. In the seventy years since the Investment Company Act of 1940 was passed, the industry has worked with the SEC to strengthen and modify the regulatory system to respond to innovation and market changes. The mutual fund industry has recognized that investor confidence is the key to its long term success and that confidence only comes from the trust that investors are appropriately protected. It really should be no surprise that investors too have embraced the mutual fund regulatory model, making it the single, largest repository of investor funds.

June 24, 2010

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