‘Flash Crash’ Panel Emphasizes Computer Trading’s Problems

After last May’s gigantic, all in a single moment, financial market sell off – now known as the “Flash Crash” – a joint-committee was created by both the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) to review the causes.  Friday saw the publishing of the joint SEC-CFTC committee’s report and, in short, it emphasizes that change needs to occur to limit the affect of some of the abusive practices of computer-based traders that lead to tremendous market volatility.

From the very beginning of the report they say:

“The events of May 6, 2010 and the subsequent investigation, analysis, and reporting by the staffs of the [CFTC] and the [SEC] have highlighted many important policy and practice issues in today’s securities and futures market environment…We cannot overstate the importance of addressing the most pressing issues highlighted here. While many factors led to the events of May 6, and different observers place different weights on the impact of each factor, the net effect of that day was a challenge to investors’ confidence in the markets [emphasis mine].”

I want to highlight one of potentially dangerous factors affecting stock market volatility, the number of firms with so-called “naked access” to the financial markets.  Normally, in order to be right in the midst of a day’s trading activity, a firm has to be a registered broker with one of the exchanges.  These brokers have to apply for access and that access is granted on a very limited basis and with very rigorous scrutiny.  However, a practice has grown where the brokers who have access effectively lease it to those who do not have it.

This sounds like a minor quibble.  But ultimately it means that firms that don’t have to adhere to the rules have access to the financial market exchanges.  The joint report of the CFTC and SEC states:

“…the direct access to the market of large numbers of unregulated, and in many ways, unsupervised entities create risks of erroneous trades or manipulative or other violative strategies.”

These manipulative and violative strategies do in fact take place, frequently, and in large numbers.  Over the course of my career as a portfolio manager the amount of volatility in the financial markets increased dramatically.  The anecdotal evidence for the manipulation was in the often dramatic price movements of the Davis Appreciation and Income’s portfolio’s holdings within the last five minutes of the trading day.  Often these price movements were +/- 5.0% and took place in a new vacuum.  That is, there was no news that day or on subsequent days that could be ascribed as a reasonable cause for such price volatility.  The volumes being traded in those last few minutes was also enormous – a strong indication of computer traders at work.

In conclusion, as I have highlighted many times before in this forum, you cannot take the human out of investing.  When you do, such as in the case of computer trades, you remove all of the human wisdom from the markets, and in times of high trading volatility you also remove much of the intelligence.  The net effect is a whittling away of the confidence of investors, some of whom never return to the financial markets again.  It is important to note that the primary justification for computer based trading strategies is that they provide liquidity to the financial markets.  Yet, if the number of participants dramatically decreases, which has been borne out by trading data subsequent to the “Flash Crash,” then liquidity has lost its breadth part of the breadth and depth equation.  Despicable.  The financial markets have to work for everyone, not just the narrow band of profit hungry computer traders.

Jason