By Zachary A. Goldfarb
Washington Post Staff Writer
Wednesday, May 19, 2010; A15
Twelve days after the stock market took a historic plunge that raised fears of another financial crisis, federal officials are still struggling to understand what went wrong even as they offer proposals for how to avoid another "flash crash."
Regulators offered several possible explanations Tuesday for what was behind the nearly 1,000 point decline in the Dow Jones industrial average May 6. Without identifying any firms or transactions behind the chaos, regulators said in a report that the losses were probably magnified by outdated and conflicting rules as well as a "complex web of traders and trading strategies" in traditional and more speculative markets.
At the same time, regulators offered a prescription aimed at curbing excessive market volatility. The Securities and Exchange Commission announced that in coming weeks it would require that exchanges pause trading in a stock if it declines more than 10 percent in any five-minute interval.
The report and the new proposal to curb trading reflect a growing recognition by federal officials that they have not adequately regulated the nation's trading hubs at a time when events in some corners of the financial market can spill over rapidly into the rest of the market.
The events of May 6 -- when the price swings of some stocks defied market fundamentals -- dealt a setback to confidence in a financial system already battered by concerns about a worsening debt crisis in Europe.
The SEC's proposal is a response to several lessons of May 6. Several existing triggers, or "circuit breakers," that would normally pause trading were outdated and did not go into effect. Meanwhile, different rules governing when to stop trading led to irregularities across the markets.
"We continue to believe that the market disruption of May 6 was exacerbated by disparate trading rules and conventions across the exchanges," SEC Chairman Mary Schapiro said. "I believe that circuit breakers for individual securities across the exchanges would help to limit significant volatility."
The new rules would apply across all trading venues. The halt in trading would last five minutes.
A full account of what happened may take months to complete, as it did after the spectacular market crash of Oct. 19, 1987, also known as Black Monday.
While today's markets are nearly all electronic, making collection of data easier, the amount of data is far larger. In 1987, about 600 million shares were traded on Black Monday. On May 6, 19.5 billion shares were exchanged in 66 million trades.
A 151-page report on the causes of the May 6 disruption released by the SEC and the Commodity Futures Trading Commission offered preliminary hypotheses for what happened.
The regulators' report sheds no light on which firms and traders helped cause the volatility. But the report underscores how the fate of the stock market today is guided largely by speculators making bets on far-flung trading hubs that can nevertheless have a major influence on the prices of blue-chip stocks.
One leading theory is that large "sell" orders in a financial instrument linked to the performance of the Standard & Poor's 500-stock index, and traded in Chicago, may have triggered a series of trading strategies that prompted firms to keep selling.
Trading in the actual S&P 500 is limited to the number of shares outstanding of the 500 companies listed in that benchmark stock index. But trading in the financial instrument that may have fueled the May 6 tumult, called an e-mini S&P 500, and similar instruments is virtually unlimited.
These securities allow investors to bet on the overall direction of the stock market without buying shares of companies. However, they also can amplify market distress, creating a feedback loop that then intensifies selling in the actual stock market.
But that's just one theory.
Other factors that may have fed the volatility include the fact that key financial firms, whose job is to provide buy and sell shares during times of stress, withdrew from the markets as volatility increased.
As those companies pulled out, different rules on different exchanges about when to pause trading made it hard to match buy and sell orders. Sell orders overwhelmed some exchanges, driving down share prices.
Also contributing to the chaos may have been the use of "stub" quotes that allow market-makers -- firms that agree to buy and sell shares to ensure that investors can make trades -- to technically stay active in the market as is required by some exchanges.
But "stub" quotes are usually are far below or above what the market is asking and are almost never executed. On May 6, trades were executed at extremely low "stub" prices. Exchanges have since canceled most of those trades.
Regulators are also examining whether there were problems with exchange-traded funds, which allow investors to trade baskets of stocks or commodities as though they were single stocks.
The SEC is also facing intense pressure from Capitol Hill to rein in high-speed, math-based trading that some lawmakers blame for the market chaos.
"Seventy percent of the daily trading volume is by black-box computers that, for the most part, do not care about the intrinsic value of the stocks underlying their trades," Sen. Ted Kaufman (D-Del.) said Tuesday.
The report did not weigh in on whether this type of trading fueled the market chaos.