The regulatory origins of the flash crash

Larry Ribstein —  24 August 2010

On May 6, 2010, the market suddenly swung a thousand points. Nobody really knows why.

But Dennis Berman, in the WSJ, has a clue – maybe the regulators did it. He notes that today’s market results from 1975 market reforms aimed at eliminating market makers who were increasing trading costs by increasing spreads:

[B]y the time the last big market reforms were issued in 2005, the intent was to “give investors, particularly retail investors, greater confidence that they will be treated fairly,” the SEC said at the time.

But now those greedy market makers have been replaced by machines, high-frequency trading and fragmented markets, leaving nobody with “the responsibility . . . to step in at a time of distress like the flash crash.” So

we have traded cheaper up-front costs for unknown back-end ones. That is exactly what is spooking the same investors the SEC vowed to protect in 2005.

Congress is now thinking of fixing this system, apparently suggesting that maybe investors are not, in the words of Delaware’s Senator Kaufman, “best served by narrow spreads.”

And we’ll undoubtedly get a regulatory fix. But Berman quotes Vanderbilt’s William Christie: “It’s kind of like a balloon—you squish one side and it pops out the other.”

Here’s some more thoughts:

  • Maybe the government shouldn’t mess with markets unless it really understands how they function and the costs of regulation. Which it usually doesn’t.
  • Often one regulation leads to another regulation that fixes the first one, and then to another one that fixes the second one, and so on.
  • Insiders have a function – there’s usually a reason why markets are willing to tolerate their existence and profits.
  • “Fairness” is often inconsistent with efficiency.
  • E.g., insider trading?

Larry Ribstein

Posts

Professor of Law, University of Illinois College of Law

15 responses to The regulatory origins of the flash crash

  1. 

    But here is the thing, electronic trading was implemented to guarantee execution to small investors. Crash of 1987, no flash involved, witnessed an extreme inability for small investor to get trades executed. In moments of great volatility the Market Makers choose not to make markets. Hence the birth of SOES, leading to the ECN revolution… and here we are. Along the way the Exchanges became profit seeking vehicles. Given the intellectual inferiority of regulators and legislators, abusive gaming of the system was inevitable. What’s the next move?

  2. 

    It was about a century and a half ago that it was observed how often regulatory measures were entitled “An Act to Amend an Act . . .”

  3. 

    Its not a question of “more” regulation, its a question of “better” regulation.

  4. 

    I accept that ongoing innovation calls for ongoing assessment, but:

    But now those greedy market makers have been replaced by machines, high-frequency trading and fragmented markets, leaving nobody with “the responsibility . . . to step in at a time of distress like the flash crash.”

    The WSJ’s Berman fails to mention that the SEC has installed circuit breakers. Two possible reasons for the omission come to mind. Each reflects great discredit upon him, as does the rest of his piece. My sainted high school teachers would have had my *ss for submitting something like it.

    • 

      We are heading into a midterm election and the economy is whimpering instead of roaring as promised. I expect the politicians to look for scapegoats, and I expect them to look everywhere but in the mirror. Evil scientists are using computers to steal the public’s money? Sounds like a promising line of patter.

      1. I gather that flash trading involves well-connected–double meaning intended–traders getting access to orders maybe .03 seconds before other investors. That’s a long time computerwise. It means that the playing field is not level, and the practice should be stopped. But:

      2. Congress is now thinking of fixing this system, apparently suggesting that maybe investors are not, in the words of Delaware’s Senator Kaufman, “best served by narrow spreads.”

      Let me get this straight. If I buy a stock and immediately change my mind (maybe because I placed my order incorrectly), I can return it at a low commission for essentially the price I just paid. Tor reasons which Senator Kaufman has not explained in terms I understand, this may well be a bad thing.

      3. Speaking of not understanding things, here’s a quote from the linked WSJ piece:

      Bigger institutional investors, says Justin Schack, vice president of market-structure analysis at New York brokerage Rosenblatt Securities, are suspicious. (p)They say, “I still feel like someone is screwing me,”‘ Mr. Schack adds. Even though they have benefitted from shrinking trading costs, he says, “trading feels different than it used to.”

      Call me a fuddy-duddy, but I’d expect a VP of market structure analysis to talk about, you know, market-structure analysis in an interview and not about feelings. (To be fair to Schack, I don’t know the totality of what he told the interviewer.) Perhaps the studies on which to base an informed conclusion have not been published or done; perhaps the systems to gather the necessary data have not even been put in place.

      4. I take flash crashes seriously. Unfortunately I also take seriously the possibility that the government’s reaction may do more harm than good.

  5. 

    Publius …

    obviously you are approaching this from a rational and reasoned point of view of “Hedge Fund Scum” … I’m sure your ignorance knowledge of Hedge Fund trading is only exceeded by your ignorance knowledge of free markets and security trading in general …

  6. 

    Yesterday the Financial Times on its front page referred to poorly capitalized firms in Eastern Europe with very poor internal controls as playing a role:

    “The subcustodian chain can bury the identity of high frequency traders in eastern Europe and elsewhere who raise serious regulatory concerns.”

    Are we afraid to name names in eastern Europe?

    Of course we are….

  7. 

    “I’m not a fan of regulation” but the first thing I do is scream for more regulation.

    • 

      “I’m not a fan of regulation” but the first thing I do is scream for more regulation.

      Uhh no. I think we need SOME regulation in this case. Gotta love the “free market” libertarian marketeers when Wall Street is the biggest controlled(aka mob regulated) socialist game going.

      • 

        Rrrr called you out dead on.

        Of course you then default to the “we need some regulation” like anybody who sees through you doesn’t.

        Very predictable, very sad, very sickening.

        and to the end of your diatribe very incoherent.

  8. 

    Wow, what a ridiculous argument. The problem is with “flash trades” not regulation. HFT hedge funds allowed to see market pricing before exchanges see them so they can manipulate markets. They have become their own specialists with no check and balance of exchange bid/offer controls. And when the majority of HFT hedge funds use the same algo software — well, it just stupid is as stupid does. Wall Street are not intelligent noble beings. Get over it — they need to be controlled. They saw blood in the water and pounced. And let’s not forget most of the trades are in proprietary ECNs or Dark Pools — well outside the scope of regulatory eyes.

    I’m not a fan of regulation — but this is definitely a case for more regulation. These hedge fund scum need to be put on leashes.

    • 

      The argument is that the problem with flash trades was removing any discipline provided by the market makers, which was done via regulation. Now the market makers may not have solved or prevented the problem. Nevertheless, there are calls to solve the problem through regulation that seeks to undo regulation. Of course we could also or instead regulate hedge funds, only to discover later that they had a market function too.

    • 

      Not at all pertinent to the post. Flash trading was not remotely involved in the “crash.” HFT boys did take their ball and go home. That left thin markets, but more was at play. And that is the nut to be cracked. Ban the hell out of flash trading, will not hurt anyone but flash traders. But that has nothing to do the “crash” of 5/6.

  9. 

    Maybe the government shouldn’t mess with markets unless it really understands how they function and the costs of regulation. Which it usually doesn’t.

    You cannot be serious — there would be nothing left for the government to do. It has no substantial knowledge of either of these.

Trackbacks and Pingbacks:

  1. UrbanGrounds | Governement Should Stay Out of Stuff It Doesn’t Understand - August 24, 2010

    […] Larry Ribstein — “Maybe the government shouldn’t mess with markets unless it really understands how they function and the costs of regulation. Which it usually doesn’t.” […]