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Regulators conduct forensics on market's fast plunge

By Zachary A. Goldfarb and Jia Lynn Yang
Washington Post Staff Writer
Saturday, May 8, 2010; A01

As regulators sought to make sense of what was behind Thursday's wild gyrations in the stock market, some experts warned that Wall Street's effort to undo tainted trades could encourage the very behavior that led to the market plunge.

Regulators on Friday were trying to understand how the Dow Jones industrial average plunged nearly 1,000 points in less than an hour before rebounding 700 points. Some stocks fell almost to zero before recapturing most of their value.

Federal officials on Friday had yet to pinpoint what tipped the first domino. But, experts said, it was clear that the market chaos was greatly exacerbated by two recent advances in technology.

Computer programs designed to make lightning-fast decisions, based on complex mathematical rules, or algorithms, about what to buy and sell made massive trades without human input. High-speed trading firms kept on selling, booking losses as prices continued to decline. And electronic trading hubs had inconsistent rules about when to stop a sudden plunge in stock prices.

"You can't trade that fast, you can't have those movements, without algorithmic trading," said Robert Iati, global head of consulting at Tabb Group. "It wasn't the cause, but it was the enabler."

U.S. stock exchanges, citing "extraordinary market conditions," have canceled many trades in the hundreds of stocks that plummeted during a 20-minute period Thursday.

Some financial experts warned, however, that the decision to cancel the trades could have the unintended consequence of protecting the type of high-speed, computer-driven trading that fed Thursday's volatility.

Peter Van Kleef, president of Lakeview Capital Market Services, which helps design systems for electronic trading, put it more bluntly: "Firms that sold at ridiculous prices survive, when it's clear that their systems are so bad that they should be taken out of the market."

Rajiv Sethi, an economist at Barnard College at Columbia University, said the markets were giving the offending firms a "do over" rather than taking them out of play.

He said a fundamental problem with firms that use math-based electronic trading is that their decisions about buying and selling a company's shares are not based on factors affecting that company's bottom line. Instead, changes in share prices trigger trades. While that approach helps provide liquidity in the stock market -- electronic trading accounts for half of all trades -- it can break down in a panic. Algorithmic trades spur further algorithmic trades, prompting a stampede, Sethi explained.

The Securities and Exchange Commission and Commodity Futures Trading Commission, the two agencies in charge of overseeing Wall Street, on Friday offered little information to reassure a public deeply unnerved by Thursday's turbulence.

"Our market oversight units are reviewing trading and market data from the exchanges, self-regulatory organizations and market participants to examine yesterday's unusual trading activity," the agencies said in a joint statement. "We are scrutinizing the extent to which disparate trading conventions and rules across various markets may have contributed to the spike in volatility."

Regulatory officials said in interviews that they are exploring a range of theories, adding it's unlikely that a single big error at a financial firm precipitated Thursday's market swoon. Rather, the officials said, it was probably caused by a confluence of market events.

The officials said the review could take weeks or months given the millions of trades being examined. The SEC has set up a team to triage massive amounts of data flowing in from exchanges and other key regulators. Officials said they are also looking at whether trading in derivatives or related markets might have contributed to the volatility.

A spokesman for Nasdaq, which was in charge of canceling the trades, declined to address questions about why they were canceled, saying only the decision was coordinated among U.S. exchanges.

But the decision to cancel the trades could ease the pain of retail investors battered by the market activity Thursday.

Confidence has only returned to the market in recent months after the breathtaking losses of the financial crisis. But on Thursday, investors were already in a selling mood, unsettled by fears of a potential default by Greece and financial contagion in Europe, when the Dow saw its sharp drop.

"That kind of violence in the market undermines confidence at a time where, to be perfectly frank, we really can't afford it," said Peter Kenny, managing director of Knight Capital.

Even good news Friday -- a report from the Labor Department that the U.S. economy added 290,000 jobs last month -- couldn't revive the market. The Dow fell 139.89 points, closing at 10,380. The index was down more than 630 points -- or nearly 6 percent -- for the week.

While the New York Stock Exchange on Thursday had imposed trading limits on stocks that fell too far, rival exchanges had not. That left the NYSE and its competitors pointing fingers at one another Friday.

The NYSE said other exchanges should also take steps to slow trading when there is a significant decline in a stock's price. But the rivals said NYSE's sudden steps to slow trading undercut the marketplace.

Joe Ratterman, chief executive of BATS Exchange, a competitor to NYSE, said exchanges should probably adopt the same standards -- and these should not include rules to slow trading in rapidly declining stocks.

In Congress, Sens. Ted Kaufman (D-Del.) and Mark Warner (D-Va.) said the financial regulatory overhaul bill before the Senate should include language directing the SEC and CFTC to report to lawmakers about developments related to Thursday's trading. Meanwhile, Rep. Paul Kanjorski (D-Pa.), ordered SEC officials to brief lawmakers at a hearing scheduled for Tuesday.

"We cannot allow a technological error to spook the markets and cause panic," he said in a letter to SEC chairman Mary L. Schapiro. "This is unacceptable."

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