In the search for the problem at the root of the apparent breakdown of trading on May 6, launched with such fanfare and urgency but so far showing scant results, investigators may have to confront an awkward question: What if there wasn’t any problem?
Everyone in a position of authority seems to have jumped to the conclusion that something went seriously wrong when the Dow Jones Industrial Average suddenly lost nearly 1,000 points and that it was only a matter of identifying the culprit(s). Securities and Exchange Commission Chairman Mary L. Schapiro called the plunge “unacceptable.” Even before knowing the cause, stock exchanges canceled trades that occurred between 2:40 p.m. and 3 p.m. at prices 60% above or below the price at 2:40 p.m. Nasdaq alone canceled more than 10,000 trades involving at least 1.4 million shares.
Various theories have surfaced, only to be discarded. First there was the “fat finger” theory, in which an errant trader supposedly entered some extra zeros to a sell order for Procter & Gamble (PG) shares, which sent the market into a tailspin. But apparently no such order existed. Then the focus shifted to trades on an S&P 500 futures contract. But they didn’t seem all that large or otherwise aberrational.
High-frequency trading operations — which use supercomputers to make super-fast trades — came under the spotlight, and apparently many (but not all) of them halted operations due to the extreme plunge in the market, causing liquidity to dry up. But that was a reaction to the market breakdown, not a cause. And there’s nothing to say that high-speed traders are required to trade at all times. They’re not market makers.
If there was genuine human or electronic error, something akin to an act of God, then there’s a case for overturning the market results and unwinding trades. But if not, the case for intervention doesn’t seem nearly so clear.
There’s no question that some shares traded at what seem like absurd prices, such as consulting firm Accenture (ACN) at a penny. It seems increasingly likely that these trades were entered into by parties using sophisticated computerized trading algorithms, since presumably no rational person would sell Accenture at a penny. It also seems likely that only someone using a computer would enter a buy order at a penny for a stock that had been trading above $40. I’m told that there is a breed of investor who, using computers, every day enters one-penny bids for a host of blue chip stocks. In any event, at the height of the crisis that Thursday, buy and sell orders for thousands of shares were executed on electronic exchanges at a penny and similarly ridiculous prices.
Congress and the SEC should find out who, exactly, placed those orders and under what circumstances. If the trades resulted from sophisticated algorithms that failed to take into account the possibility of such volatile trading conditions, do those investors deserve to be bailed out by having the trades unwound? Should MIT-trained engineers turned professional traders be protected from their lack of foresight? Conversely, should those traders who devised programs to take advantage of such a free fall be denied their profits?
I, for one, don’t think so. Critics of the government’s Troubled Asset Relief Program were quick to invoke moral hazard as a basic guiding principle, the argument being that risk of loss is an essential element of investor discipline. With the banking system, there were overriding national interests which argued for a bailout. But shouldn’t moral hazard apply to investors in the stock market, especially if those investors are professionals engaged in massive amounts of trading?
The market plunge was unnerving during the brief period it lasted, and there may well be reforms that should be implemented going forward. It doesn’t seem to make sense, for example, to have trading halts and circuit breakers unless they apply to all exchanges. But that doesn’t mean the rules should be changed in the middle of the game and applied retroactively, arbitrarily benefiting some at the expense of others. Canceling trades that met the 60% threshold — but not those just below it — seems arbitrary and unfair.
I’ve long warned of the risks that standing orders pose for ordinary investors because they remove human judgment from a decision to buy or sell securities. Countless investors have used limit orders and later regretted it when the market subsequently moved against them. No one ever suggested that they deserved to have the trades unwound.
The May 6 plunge was an extreme event. It needs to be understood and its lessons applied. But the market regained its footing and functioned. For the overwhelming number of investors, it appears to have done no lasting harm. Most people didn’t even know it was happening until it was over and stock prices had recovered. Those who jumped into the fray and traded, using computers or otherwise, may well have deserved the outcomes they got.
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