SEC launches inquiry into market's 'flash crash'

By Zachary A. Goldfarb
Washington Post Staff Writer
Friday, May 21, 2010

The Securities and Exchange Commission is looking at whether key financial firms broke securities laws when they stopped buying and selling stocks during the "flash crash" on May 6, helping fuel the historic plunge in prices.

SEC Chairman Mary Schapiro said at a congressional hearing Thursday that these companies, known as market makers, might have violated a legal duty to continue to buy and sell during the rapid decline.

"We don't have evidence yet of market makers who had affirmative obligations from withdrawing from the market," Schapiro told the Senate banking committee. "It is absolutely something that we're looking at and we've incorporated our enforcement division into our ongoing investigation."

Schapiro's comments are the first signal that the regulator might seek to sanction firms if they contributed to the decline of nearly 1,000 points in the Dow Jones Industrial Average. The agency previously had not suggested that wrongdoing could have been behind the market chaos.

At the hearing, the chairman of the Commodity Futures Trading Commission said the regulator would look into reining in some of the high-speed, mathematics-driven trading that aggravated the volatility.

"A lot of the algorithms are very . . . dumb," said CFTC Chairman Gary Gensler. "We can't stop technology, but I think that we have to update our regulations to stay abreast of this."

Regulators suspect that automated trading in a speculative financial instrument linked to the performance of the Standard & Poor's 500 stock index contributed to the market plunge.

But even if trading in that instrument helped fuel the start of the decline May 6, regulators say the failure of market makers to remain active buyers and sellers of shares sent prices down even more.

Many long-time market makers -- often a major bank or brokerage whose role is to facilitate trades by others -- required to remain active in the market even during times of market stress. But many other upstart firms, often using high-speed electronic trading, face no such legal obligation to keep buying and selling shares.

"I do believe one of the things we absolutely have to look at is the fact that many affirmative obligations of market makers have been eliminated by the markets over the years," Schapiro said. "So one of the things we will be looking at very carefully is the creation of affirmative obligations again."

The SEC has discounted the possibility that an error at a financial firm caused the crisis, or that outright criminal behavior such as hacking or terrorist activity was behind the market chaos.

The agency has largely blamed outdated and inconsistent rules governing trading across a wide array of market venues, as well as speculation in electronic futures markets for fueling the plunge.

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