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What the Flash Crash Has Taught Us

The stomach-churning cliff-dive two years ago shined a light on how U.S. equity markets can be improved. But the changes necessary are hardly radical.

Since May 6, 2010, the U.S. equity trading industry has been going through the five stages of grief. We are currently in the fourth stage, depression. It is not clear to me if the industry will ever move on to the next and final stage of acceptance and recognize that U.S. equity market structure is mostly okay and only requires a few tweaks around the edges. 

I do not believe that the so-called flash crash, and the increased awareness of various market structure foibles, has had a long-term impact on asset allocation decisions. Country equity fund flows continue to be highly correlated with emerging markets continuing to win market share. But the reexamination of market structure in the wake of the flash crash helped identify room for improvement in three areas.

First, the single-stock circuit breakers should be replaced with a rule (limit up/limit down) that would not even let wildly mispriced orders into the market. Second, there should be greater harmonization of rules across the equities and the derivatives markets, especially since there will be an increased number of points of failure when over-the-counter (OTC) derivatives shift to exchange-like trading platforms called swaps execution facilities (SEFs) and trade more electronically.

Third, there should be increased flexibility in the way stocks can trade under the Regulation National Market System (NMS). Currently, stocks across any market capitalization all trade the same way.

There is broad agreement that replacing the single-stock circuit breaker with a limit up/limit down rule has not advanced much. Meanwhile, we are seeing stocks unnecessarily trigger the circuit breaker for price movements that are natural and with good reason. Within a given timeframe, 133 circuit breakers were triggered by news events (is this really necessary?) while only 25 circuit breakers were triggered by bad prints or fat fingers.

Regulatory harmonization is a little bit trickier. The institutional differences between the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) and the different needs of their respective markets mean they will not see eye to eye on everything. Furthermore, industry participants currently regulated by one commission would not want to switch to another. But this need to have a common regulator for a particular asset class was recognized under Dodd-Frank, and the SEC will regulate equity swaps. So it’s a start.

In terms of flexibility, it makes sense to have a single set of rules for all equity and equity-like products. Investors should not have to think about how the rules of the game change depending on the security they trade. The matching of buyers and sellers does not need to be a Rube Goldberg. And yet, when a single rule set is coupled with the notion that there should competition among the execution venues, we get a market structure that is overly complex and too constrained.

There should be more flexibility around how different types of stocks and exchange-traded products trade. A few modest proposals that have been floated in the past include a variable minimum tick size, changing how block orders can be traded and printed, and other forms of limited exemptions. I am not advocating any particular change. The SEC should solicit comments for ideas on what kind of pilot program would help us understand what rules would best fit securities with different liquidity characteristics. 

I am not predicting that any of this will happen. There is no question that the SEC has a significant number of important issues to decide in the coming months. The U.S. equity market structure is still one of the best in the world. But the flash crash shined a light on a few areas that could be improved.

Adam Sussman is the director of research at the TABB Group, based in New York City.

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