Wild day on Wall Street leaves electronic exchanges under scrutiny

By David Cho and Jia Lynn Yang
Washington Post Staff Writer
Friday, May 7, 2010; A01

Stock markets went haywire on Thursday. Shares were already falling over fears of fiscal problems in Europe when something, perhaps a structural flaw in U.S. markets, dragged prices into a historic and breathtaking plunge.

In the span of minutes, the Dow Jones industrial average plummeted nearly 1,000 points from its previous close -- a record -- and whipsawed back up, creating one of the wildest trading days ever. The Dow still closed down more than 3 percent, and more unrest may be in store for Friday as market officials and regulators try to sort through the aftermath.

Rumors about the cause of the chaos were rampant on Wall Street and in Washington. Some traders speculated about human error, such as an electronic trade of stocks entered with the wrong amount. Regulators offered little clarity, saying they would investigate.

Some price swings of stocks defied logic. The shares of Accenture, a consulting firm, fell from $40 to a single penny and then back to $40 again. Procter & Gamble traded at $54 on the New York Stock Exchange. But at the same time, Nasdaq was reporting that the company's shares were selling for $39.

Thursday's dramatic gyrations added fuel to the biggest policy debate in Washington: how to regulate Wall Street. That billions of dollars in stock-market value could be wiped out so abruptly, with such a lack of certainty about the cause, is a reminder of the high stakes involved in a system that is little understood by average investors.

The confusion also highlighted the evolution of stock trading, which some market officials say has happened too fast without adequate safeguards. The NYSE has "circuit breakers" in place to pause the trading of stocks during a panic. But investors can also trade stocks on 10 electronic platforms that have sprung up in the shadows of the NYSE in recent years and generally do not stop unrestrained selling.

Senior executives of the NYSE said the Securities and Exchange Commission has given the exchange's competitors too much freedom, not ensuring that these smaller trading platforms have necessary protections.

Lou Pastina, the NYSE's executive vice president of operations, said the system set up by the SEC exacerbated problems on Thursday. When the sell-off started, the NYSE paused the electronic trading of several stocks and moved to traditional auctions of stocks with a middleman. The goal was to stem the panic and find rational buyers.

While the stocks were paused on the NYSE, sellers moved to other electronic exchanges such as Nasdaq and Instinet. So many sell orders came in at once that some stock prices listed on those platforms fell to near zero. Shortly after, trading of those stocks started up again on the NYSE at the paused prices, leading to wide disparity in costs among exchanges.

"How did this happen? You've got to ask the SEC," said Ted Weisberg, president of Seaport Securities and a trader for more than 40 years. "The bottom line is the government created a trading mechanism with a lot of different marketplaces. Now they probably have 40 or 50 different venues where stocks trade. I don't know what their rules are. The public doesn't understand. This is another perfect example of the government changing the ground rules and we end up with unintended consequences."

The SEC declined to respond to those comments, saying in a statement that it would "review the unusual trading activity that took place briefly this afternoon."

"We are also working with the exchanges to take appropriate steps to protect investors pursuant to market rules," the statement said.

In 2007, the SEC put in place new rules for how stocks are traded, led by then-Chairman Christopher Cox. The goal was to give investors more control over how their trades were executed and to guarantee the best price when they buy stocks.

When the NYSE received an order for a stock, for instance, the rules required the exchange to route the order to the platform offering the best price.

The new SEC rules toppled the dominance of the NYSE. Trading of its own listed stocks dropped from 85 percent to 21 percent, said James Angel, a professor at Georgetown University's McDonough School of Business.

As a result, a single entity can no longer put a stop to panicked selling. The markets Thursday were a preview of what happens when other trading venues take over, he said.

"We are dangerously unprotected from a real-time meltdown," Angel said.

Market officials and regulators are now unwinding millions of the trades that occurred on the electronic exchanges Thursday. As a result, the markets could be in for "an ugly" morning, Pastina said.

Nasdaq took the extraordinary measure Thursday of canceling all trades of stocks that occurred from 2:40 to 3 p.m. at prices 60 percent below the price listed prior to that period. The list of stocks affected is on its Web site.

Some government officials and market analysts said that even if the massive plunge in the afternoon was the result of technical problems, the chaos intensified the uncertainty over whether a fiscal crisis in Greece could turn viral and spread across Europe, particularly to larger economies such as Spain. News channels flashing in New York showed scenes of protests in Greece, raising doubts about whether the country would adhere to the austerity measures required under a $140 billion financial rescue package offered by the European Union and International Monetary Fund last week.

The Dow closed the day down nearly 350 points, or 3.2 percent, its worst single-day drop in more than a year. The Standard & Poor's 500-stock index, a broader measure of U.S. markets, fell 37.75, or 3.2 percent, to 1128.15, while the tech-heavy Nasdaq composite index dropped 82.65, or 3.4 percent, to 2319.64.

The sell-off spread to Asia in early trading Friday, with Japan's Nikkei average down as much as 3.8 percent and South Korea's Kospi index off by 2.9 percent.

Staff writers Tomoeh Murakami Tse in New York and Zachary A. Goldfarb in Washington contributed to this report.

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