Last week's stock plunge largely caused by big Wall Street firms, SEC chief says

By Zachary A. Goldfarb
Washington Post Staff Writer
Wednesday, May 12, 2010

Major Wall Street firms retreated from the market Thursday at the very moment when they were most needed to support normal trading, in what a senior federal regulator called the "most significant" factor behind the stock market's dramatic volatility.

Securities and Exchange Commission Chairman Mary Schapiro discounted Monday many of the most widely discussed theories behind why the markets panicked. These include an erroneous "fat finger" trade that started it all; hacking or terrorist activity; unusually large trading in shares of Procter & Gamble, a component of the Dow Jones industrial average; and trading in derivatives.

"The markets failed investors," Schapiro said. But, she added, "at this point, we are unable to point to a single event which could be the sole cause."

In prepared testimony before a congressional panel probing the market turmoil, Schapiro said a key cause was the sudden withdrawal from the market of firms that traditionally play a role as a "liquidity provider" by purchasing stocks when prices are declining and selling stocks when prices are rising.

Under securities laws, some of the firms -- often associated with a major bank or brokerage -- are required to remain active in the market even during times of market stress. But many of these more established liquidity providers have been displaced in the past decade by high-speed electronic trading firms that face no such legal obligation to provide liquidity.

The SEC named no names. Some of the largest established liquidity providers include Citadel Securities, Barclays Capital and Merrill Lynch, which are part of financial conglomerates. Less-known firms that are recent comers to the industry include Getco and Jump Trading. These companies are smaller operations that focus exclusively on electronic trading.

Schapiro said liquidity providers stopped buying stocks that suffered large price declines Thursday, "whether because of an intentional decision to withdraw or because of specific market practices," without specifying those practices. She said there is no indication that government rules were breached.

Regulators have spent the past several days analyzing millions of trades but have yet to determine what was behind Thursday's volatility. On that day, the Dow Jones industrial average rapidly fell nearly 1,000 points before rebounding 700 points, as many individual stocks suffered dramatic plunges before reclaiming most of their declines.

Schapiro said that the investigation's preliminary findings will be issued Monday but that the task at hand is huge: reviewing millions of trades in billions of shares.

Schapiro identified as another key cause of the volatility the different rules among exchanges for when to slow or stop trading in a fast-declining stock. On Monday, Schapiro gave U.S. stock exchanges 24 hours to devise a marketwide plan to stop or slow trading in stocks that are falling rapidly.

The SEC said on Tuesday that it had received the exchanges' recommendations but would not say what they were.

Meanwhile, the SEC and Commodity Futures Trading Commission announced Tuesday the creation of a joint task force to discuss emerging regulatory issues, with an initial focus on Thursday's volatility. The task force will look at regulatory loopholes and any possible gaps between areas of the market overseen by the two entities.

Members of the committee include, among others, Brooksley Born, a former CFTC chairman who warned more than a decade ago about the risks of derivatives; former SEC chairman David S. Ruder; and former Vanguard chief executive Jack Brennan.

Schapiro said Thursday's volatility raises several regulatory implications. She said the SEC would look at "timeout" mechanisms that pause action in the market or particular stocks during times of distress.

She said the automated nature of today's trading might require additional timeout mechanisms. In addition, she said the SEC is considering limits on the prices at which trades can be executed and limitations on the size of market orders.

Schapiro also said the agency would look at whether short-term trading strategies, such as those that use computer analysis to make split-second decisions, need to be curtailed.

The SEC has several proposals outstanding that would address some of these issues. One proposal would beef up risk-management controls for brokers. Another would make it easier to capture and analyze trading patterns across markets.

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