Stock free fall may prompt new rules

The kind of bungee jump that stocks
took Thursday, plunging abruptly before snapping partway back in a brief frenzy
of electronic trading, has worried market operators and experts on trading for
some time.

Despite a surprising consensus
about what needs to be done, federal regulators have not shown much urgency in
rewriting the rules governing an increasingly fragmented, and computerised,
trading system.

That appears likely to change after
the wild, record-setting ride that briefly sent the market spinning out of
control. President Obama and lawmakers called for action, and regulators at
agencies including the Securities and Exchange Commission promised to deliver,
even as they struggled to understand the origins and particulars of Thursday’s
chaos.

The gist of the solution, according
to regulators, traders and academics is that markets need uniform rules for
intervening when a stock goes into free fall.

“We need to work out a common
consensus as to how markets react when stock prices start to plunge in very
short time periods,” said Richard G. Ketchum, the chief executive of the
Financial Industry Regulatory Authority, the industry group that polices brokers
and exchanges.

Asked why exchanges had not already
agreed on such rules, Mr. Ketchum responded: “I can’t say that I have a good
answer for that. We should have. And now we must.”

The much-discussed “stock market” —
with its connotation of a single entity — is a misnomer. Investors can buy and
sell stocks through about 50 markets in the United States. Most of the trades
are placed through computer networks, at the direction of computer programs,
and orders are routed automatically to the market offering the best price.

It is a system that sometimes spins
out of control if the computerised sellers cannot find enough buyers. Last
year, on 28 April, 2009, the stock price of Dendreon, a Seattle biotechnology
company, plunged 69 per cent in 70 seconds before trading was halted. When
trading resumed the next day, most of the loss was instantly erased.

The same pattern unfolded Thursday,
as shares in companies including Procter & Gamble fell precipitously.

Because such declines can reflect a
temporary shortage of buyers rather than a permanent loss of value, some of the
markets impose “circuit breakers” that pause trading to protect sellers from
taking unnecessary losses. The New York Stock Exchange, for example, briefly suspended
trading in some shares on Thursday, then slowed the pace of trading to give
sellers a better chance to find buyers.

But there are other ideas to
keeping computerized markets in check. Lawrence E. Harris, a finance professor
at the University of Southern California, said regulators should simply require
all sellers to specify a minimum price below which they do not want to complete
the sale of their shares. Market orders, placed at the best available price,
can be too risky in the fast-moving age of electronic trading.

On Thursday, some sellers placed
orders that were not fulfilled until prices had plunged as low as a penny a
share. If sellers had placed “limit orders” instead, those transactions would
not have happened, Professor Harris said.

“Electronic exchanges in most other
countries only accept limit orders,” said Professor Harris, a former SEC chief
economist. “Without any mechanisms to stop the market, we just had stocks
falling through the ice.”

But Rafi Reguer, a spokesman for
the electronic exchange Direct Edge, said retail investors liked market orders
because limit orders could be rejected, forcing the seller to try again, in
some cases at a lower price.

“Sometimes what people value is the
certainty of execution,” Mr. Reguer said.

Experts also note that the value of
limit orders can be subverted if investors routinely set unrealistically low
limits, to avoid the inconvenience of having their orders rejected.

The BATS Exchange, a large
electronic exchange based near Kansas City, rejects orders if the price would
be more than 5 percent or 50 cents away from the last completed transaction.

During the market panic on
Thursday, between 2:40 and 3pm, BATS prevented more than 47.6 million orders
from executing — more than 95 percent of all orders during that period,
according to Randy Williams, a spokesman for the company.

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