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Senator Kaufman Says Evidence Shows May 6 Flash Crash "No Isolated Event"

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Speaking of circuitbreakers, in a speech on the Senate floor Wednesday, Senator Ted Kaufman pointed to evidence that the May 6 flash crash may not have been an isolated event. On June 2, stock in Diebold, a technological services company, experienced a “mini-flash crash” of its own, plunging 35% and recovering fully in only minutes. The sudden decline and rebound appeared to be the result of an “electronic overreaction” to news reports of Diebold’s long-expected settlement with the Securities and Exchange Commission (SEC) over fraudulent accounting practices.

“Regardless of what caused Diebold’s ‘bungee jump’ or the May 6 market meltdown, we should all agree that such unusual market activity strikes at the very heart of our market’s credibility,” said Kaufman. “Regulators should add to their list the need to examine whether the precipitous drop in Diebold stock was the result of high frequency traders who can subscribe directly to market data and news feeds and perhaps had programmed faulty correlations into their algorithms to react to breaking news events.”
 
“With so much of the marketplace dominated by high frequency traders employing similar strategies,” Kaufman continued, “an overreaction by a few algorithms looking to trade instantaneously on the basis of imprecise correlations could trigger a dramatic plunge.” And while the algorithms’ calculations may be accurate “most of the time,” the “chaos that ensues when they are not inexcusably undermines investor confidence,” he said.

Full speech by Kaufman continuing his righteous crusade against HFT below:


Mr. President, I have always believed the two most important things that make America great are democracy and free capital markets.  But over the last year, as many of my colleagues are aware, I have become deeply concerned that the credibility of our stock markets – one of our nation’s most precious national treasures – can no longer be taken for granted. 

On May 6th, when the markets yo-yoed up and down, plunging 573 points in a mere five minutes before recovering 543 points in the next 90 seconds – it was nothing less than an embarrassment. 

The strength of our stock market depends on its ability to establish an accurate price for a company's fundamental value that reflects a consensus among buyers and sellers at any given moment. In that capacity, the markets failed, in fact they spectacularly failed, for a harrowing 20-minute time period.

In the aftermath of May 6th, the integrity of our markets has been questioned, and investor confidence has been shaken.  In order to restore market credibility and instill confidence among the investing public, regulators and lawmakers alike must act wisely but urgently to fix the structural schisms that plague today’s capital markets.

That is why I am encouraged, and relieved, that Mary Schapiro, the Chairman of the Securities and Exchange Commission, clearly understands what is at stake.  Testifying before the Senate Subcommittee for Securities, Insurance, and Investment on May 20th, she said: “I believe the markets exist for public companies to raise capital, to build businesses, and create jobs, and they exist for investors to support that activity. And those are the number one and number two purposes of markets. And everything else from my perspective has to be put into the context of those two goals.”

At a panel last week in Montreal at the International Organization of Securities Commissions, Chairman Schapiro reiterated that point, saying the SEC needs to: “[E]xplore whether bids and orders should be regulated on speed so there is less incentive to engage in this microsecond arms race that might undermine long-term investors and the market’s capital-formation function.  The markets have to serve that function for companies to raise money, create jobs and allow the economy to grow…We are also looking at whether and to what extent pre-trade price discovery is impaired by the diversion of desirable, marketable order flow from public markets to dark pools.”  

I couldn’t agree more with Chairman Schapiro.  May 6th made clear what many have long claimed: today’s overly-fragmented marketplace, which seems to favor speed over substance, and trading over investing, may be inhibiting the capital-formation process and failing to protect the interests of long-term investors.  If that is the case, then regulatory action is needed urgently.  

Simply put, do stock prices adequately reflect the economics of the companies they represent?  On May 6th, when liquidity vanished and established companies like Accenture traded briefly for a penny a share, the answer to the question of whether our markets are performing their central function was clearly no. 

But rather than an aberration, it appears that the May 6th flash crash was no isolated event.   On June 2, we saw yet another “mini-flash crash” in the stock of Diebold, a technological services company. 

Prior to 12:22 pm that day, Diebold had traded at around $28 per share and within a range of roughly 80 cents.  In the next minute, the rug was swept out from under Diebold as 399,000 shares were traded and Diebold's stock price plunged 35% to $18.  By 12:40, Diebold was once again trading at $28 per share. 

The sudden decline in price appeared to be in response to news of Diebold’s settlement with the SEC over fraudulent accounting practices, which Bloomberg began reporting at 12:25 and Diebold confirmed with a press release a little more than an hour later that afternoon.

The SEC should investigate both the manner in which the news broke and the trading activity that followed it.  In the aftermath of the extreme plunge, questions have been raised concerning the manner in which the SEC filed the complaint, which data feeds first reported it, and the electronic overreaction to the news – all of which suggest that the severe volatility in Diebold could have been largely avoided altogether.  

The SEC was actually resolving an old investigation with Diebold, the settlement of which had been previously disclosed, and not making any new accusations against the company.  But when word of the complaint reached Bloomberg or other sources, it led to a “trigger” that potentially activated algorithms programmed to react immediately to breaking news.  This may explain why trading activity in Diebold exploded shortly before the story broke publicly.  

Notably, the SEC filed the complaint manually at the US Federal District Court in DC during market hours rather than using the Public Access to Court Electronic Records (PACER) filing system. 

Mr. President, regulators should add to their list the need to examine whether the precipitous drop in Diebold stock was the result of high frequency traders who can subscribe directly to market data and news feeds and perhaps had programmed faulty correlations into their algorithms to react to breaking news events.

Indeed, with so much of the marketplace dominated by high frequency traders employing similar strategies, an overreaction by a few algorithms looking to trade instantaneously on the basis of imprecise correlations could trigger a dramatic plunge.  While the algorithms’ calculations may be accurate “most of the time,” the chaos that ensues when they are not inexcusably undermines investor confidence. 

In the Diebold case, once the algorithmic overreaction became clear, humans with actual knowledge of Diebold’s true fundamentals quickly intervened.  It is no surprise, then, that the stock price rebounded so quickly.  Though volatility has always been present in the markets, we see that without human judgment the speed of trading can indeed lead to very brief “bungee jumps” for individual stocks whenever there is a significant news event. 

At the same time, regulators should also consider whether the extreme volatility in Diebold’s stock is yet another example of sell orders breaking through a “razor-thin crust” of liquidity provided by high frequency traders.  As we saw on May 6th, the high frequency traders who fill the order books on many market centers provide only “fleeting” liquidity, particularly in periods of market stress or uncertainty.  This is because many high frequency traders prefer to continuously place and cancel small, rapid-fire orders rather than risk letting their orders sit on public venues where they would increase order book depth and promote orderly markets.  

Regardless of what caused Diebold’s “bungee jump” or the May 6th market meltdown, we should all agree that such unusual market activity strikes at the very heart of our market’s credibility. 

Even if the SEC’s circuit breaker pilot program – which would halt trading for five minutes in any S&P 500 stock that experiences a 10 percent price change in the previous five minutes – were in place, market and stop-loss orders would still remain vulnerable to a 10 percent insta-drop.  This situation undermines the confidence of long-term investors.

Mr. President, the Diebold incident and other factors from May 6th make me concerned about what our markets have become.  According to a research group survey of 145 market participants conducted in the weeks following May 6th, I am not alone. 

The Executive Summary of the survey results states overall investor confidence in the existing market structure is waning.  It says: “Barely half of all participants have at least a high degree of confidence in US equity market structure; The buy side has the least confidence in US equity market structure. This is particularly demoralizing given they are the guardians over much of our nation’s equity investments; Participants no longer believe market structure strongly supports an orderly market; Increasingly, market participants believe that the US equity market structure is not a level playing field.”

These results underscore how critical it is for regulators to address problems with the current market structure in order to restore investor confidence and protect the strength and credibility of our capital markets.

Sadly, Mr. President, the fact is that we simply do not have the data we need to assess fully the impact of market structure changes on long-term investors.  Indeed, regulators currently lack sufficient information on the routing history of orders – including those that may go through broker-dealer internalization venues, other dark pools, and multiple exchanges and ECNs before being executed.  The SEC also acknowledges it does not have: “important information on the time of the trade or the identity of the customer.”    

As Kevin Cronin, the Director of Global Equity Trading at Invesco, a retail and institutional investment fund, said at a June 2nd SEC Roundtable: “there are dimensions of cost that today we do not have the ability to really understand.”

Accordingly, I have pushed for the SEC to quickly implement tagging for large traders and a consolidated audit trail in order to gain a more granular view of the marketplace.  Once the Commission has collected the data, it should improve its internal analytical capabilities while also making the data available in masked form to the public, or at least academics and independent analysts, so that objective experts can study market performance comprehensively.

I admit there are no easy solutions, Mr. President, but we need to strive to answer the difficult questions or millions of Americans will eventually lose confidence in our markets and leave what is already starting to look like a “casino” where the house always wins.

In that regard, Chairman Schapiro again appears to be on the right track.  Regulators must consider, as she said, whether high frequency traders should be subject to speed limits and whether deep and valuable liquidity is being shielded from the public marketplace. 

Our markets should not be reduced to a battle of algorithms in which capital formation is an afterthought and long-term investors are relegated to second-tier status, nor should the public “lit” markets house only “exhaust” order flow that is passed over by those who trade in dark pools.

Perhaps high frequency traders who claim to be “modern-day market-makers” should be subject to some quoting obligations like their traditional market-maker predecessors.  Setting reasonable speed limits on how quickly such traders can withdraw their bids and offers, as Chairman Schapiro alluded to last week, could help level the playing field and make the markets safer and more stable for all investors.

I have also proposed requiring exchanges and market centers to allocate costs at least partially based on message traffic share.  Cancellations, of course, are not inherently bad - they can enhance liquidity by affording automated traders greater flexibility when posting quotes.  But with as many as 98 percent of orders placed on Nasdaq cancelled or otherwise unexecuted on a given trading day, their use is clearly excessive.  Those who choke the system with cancellations make the markets less efficient for investors.  And they should pay the price for the inefficiencies they create.

Exchanges cater to high frequency traders in a variety of ways, by electing not to charge them for high cancellation rates, and providing co-location services for their computers right next to the exchanges’ own servers.  Fortunately, co-location and direct market data feeds appear to be on the regulatory radar – the CFTC proposed a rule last week to ensure exchanges provide “fair access” for, and increased transparency of, co-location services. 

But new practices that further threaten market integrity have recently come to light. 

Several market participants, including institutional investment adviser Southeastern Asset Management, have said exchanges are releasing private information on investor orders, including details on the total shares an investor has accumulated and other data that could be used by high frequency traders to trade ahead of investor orders.  It is important to remember, Mr. President, that these potentially-disadvantaged institutional orders represent the tens of millions of Americans who invest in mutual, pension and retirement funds.

Mr. President, these market practices, among many others, underscore how critical it is for regulators to keep pace with market developments.  The May 6th flash crash and the “mini-flash crash” in Diebold a month later have sounded the alarm that the very credibility of our markets is at stake.  And while regulators must continue to rely on data to drive the rule-making process and be mindful of unintended consequences, they cannot delay in tackling the problems that leave us vulnerable to another flash crash today.

As an engineer, and a graduate of Wharton Business School, I understand and appreciate as much as anyone the importance of innovation and technological advancement.  And I want to be clear: I am not interested in banning high frequency trading or dark pools, nor am I advocating a return to a horse-and-buggy system.   

But new technologies must operate in a regulatory framework that considers both positive and negative consequences.  If the public marketplace has been reduced to a battle of algorithms in which liquidity is fleeting and inaccessible when investors need it the most, and if the deep liquidity that is so critical to establishing accurate prices – particularly during times of market stress – is largely traded in dark pools, that must be carefully but urgently remedied. 

As John Wooden, the legendary UCLA basketball coach who passed away two weeks ago, used to say: “Be quick, but don’t hurry.”  The SEC and CFTC must adopt the same philosophy, Mr. President, as they confront the great challenges before them. 

 

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Wed, 06/16/2010 - 15:27 | 417739 Muir
Muir's picture

"Regulators should add to their list the need to examine whether the precipitous drop in Diebold stock was the result of high frequency traders who can subscribe directly to market data and news feeds and perhaps had programmed faulty correlations into their algorithms to react to breaking news events."

 

__

You gotta be kiddin me!

I've seen evidence of that on my screen ever since I'm on 24+ MB/sec since 08.

This is news?

Wed, 06/16/2010 - 15:40 | 417785 johngaltfla
johngaltfla's picture

It's not news to most of us. It is to sheepledom and the regulators who spend time suckling with the banksters.

Wed, 06/16/2010 - 16:19 | 417905 Cognitive Dissonance
Cognitive Dissonance's picture

He just wanted to brag about the size of his .....er.....pipe. :>)

Wed, 06/16/2010 - 20:10 | 418359 New_Meat
New_Meat's picture

Emulex back in the '90's was a practice run.  - Ned

Wed, 06/16/2010 - 15:31 | 417759 Joe Shmoe
Joe Shmoe's picture

This is a system in extremis.  The HFTs are starting to infect and affect each other and the very variables they rely on.  

Like my doctor jogging buddy said this morning, when a patient has had all of the intervention that can be given, and all of the medications begin to impact each other and cause a whole mess of unintended results, the only thing left is dramatic intervention, such as surgery.

This won't end well.

Wed, 06/16/2010 - 16:21 | 417907 living on the edge
living on the edge's picture

One might suggest the crash/crashes are merely a glitch in the matrix. The programs are being written over as we speak.

I placed another order for gold coins today just in case. Time to average up again.

Wed, 06/16/2010 - 15:39 | 417783 Gloomy
Gloomy's picture

LOL

 

June 16 (Bloomberg) -- Fannie Mae and Freddie Mac, the mortgage firms 80 percent owned by U.S. taxpayers, plunged after regulators told them to delist their common and preferred shares from the New York Stock Exchange.

Wed, 06/16/2010 - 15:47 | 417809 Muir
Muir's picture

 I think it was manufactured locally... finest quality... superior workmanship. There is a maker's serial number... 9-9-0-6-9-4-7-X-B-7-1. Interesting. *Not* fish. *Snake* scale!

Wed, 06/16/2010 - 15:50 | 417824 4shzl
4shzl's picture

Very nice.  Ridley Scott's best work.

Wed, 06/16/2010 - 15:52 | 417834 carbonmutant
carbonmutant's picture

+10

Wed, 06/16/2010 - 16:13 | 417887 Wyndtunnel
Wyndtunnel's picture

"Wake up front runners. Time to die!"

Wed, 06/16/2010 - 22:12 | 418513 carbonmutant
carbonmutant's picture

"    It seems you feel our work is not a benefit to the public."

Wed, 06/16/2010 - 15:48 | 417814 4shzl
4shzl's picture

we should all agree that such unusual market activity strikes at the very heart of our market’s credibility

I really like Ted Kaufman, but he's fighting a battle in a war that's already lost.  The stock market has no credibility -- none whatsoever.  See the Cramer rant that TD posted yesterday for confrimation.

Wed, 06/16/2010 - 18:10 | 418143 Rick64
Rick64's picture

I have become deeply concerned that the credibility of our stock markets – one of our nation’s most precious national treasures – can no longer be taken for granted. 

 I like this one "most precious national treasures" . You would think he was talking about the constitution or something.

Wed, 06/16/2010 - 15:53 | 417837 bugs_
bugs_'s picture

They did the mash
They did the monster mash
The monster mash
It was a graveyard smash
They did the mash
It caught on in a flash
They did the mash
They did the monster mash

Wed, 06/16/2010 - 15:54 | 417838 firstdivision
firstdivision's picture

Why do I feel like this last half-hour I was molested by BigBen and Timmah?

Wed, 06/16/2010 - 15:56 | 417844 RobotTrader
RobotTrader's picture

Wonder how the Hi-Fi Robots handled this today....

LOL....

 

Wed, 06/16/2010 - 15:59 | 417851 Gubbmint Cheese
Gubbmint Cheese's picture

God Robo.. that gif is killin me

Wed, 06/16/2010 - 16:00 | 417854 Joe Shmoe
Joe Shmoe's picture

Love it.  Nice call!

Wed, 06/16/2010 - 16:21 | 417912 Muir
Muir's picture

OOuch (too painful to watch)

Mentioned here some weeks ago about a guy I knew who hadn't paid his mortgage for well over a year but felt rich because he owned 10,000s FNM shares.

schadenfreude

Wed, 06/16/2010 - 19:07 | 418238 Waterfallsparkles
Waterfallsparkles's picture

What is a shame is that they KILL all of the penny stocks because that is where Retail Traders are.  I think that FRE, FNM counted for at least 25% of the volume on the NYSE.  On a side note why did they request that the shares be delisted?

The only reason I can think of is that from what I understand that when a Stock is delisted that CDS's will then be paid and due.  Also, that there will be no capital gains on the Short positions when sold.

No reason this Company was Nationalized.  They were at the time still solvent.  Now delisting.  Someone made out BIG on this move.  I think it has something to do with the FIN Reg.  and Banks having to get CDS's out of their Companies.  It is not time for them to take profits, just in case they have to divest themselves of their Derivatives trading division.

Wed, 06/16/2010 - 20:14 | 418369 New_Meat
New_Meat's picture

the untranslateable word that we all enjoy - Ned

Wed, 06/16/2010 - 17:58 | 418121 Rick64
Rick64's picture

Looks like an old PRIDE fight. Randleman vs. Fedor?

Wed, 06/16/2010 - 19:38 | 418305 I am a Man I am...
I am a Man I am Forty's picture

Yep, and a minute later fedor puts him in a kimora and makes him tap.

Thu, 06/17/2010 - 07:47 | 419029 Rick64
Rick64's picture

Yea I remember. I have that one on DVD.

Wed, 06/16/2010 - 23:15 | 418650 TexDenim
TexDenim's picture

Hi frequency neck snapping.......

Wed, 06/16/2010 - 15:58 | 417848 Arkadaba
Arkadaba's picture

Too rich! Diebold's long-expected settlement with the Securities and Exchange Commission (SEC) over fraudulent accounting practices ....

This is the same Diebold that makes most of the electronic voting systems used in the U.S.

Wed, 06/16/2010 - 16:10 | 417878 carbonmutant
carbonmutant's picture

Because Democracy is too important to be left to chance.

http://z.about.com/d/politicalhumor/1/0/x/5/diebold_ad_stalin.jpg

 

Fri, 06/18/2010 - 12:21 | 421404 Real Estate Geek
Real Estate Geek's picture

Here's a video from the Feb., 2008 Onion:

Diebold Accidentally Leaks Results of 2008 Election Early

http://www.theonion.com/video/diebold-accidentally-leaks-results-of-2008...

Wed, 06/16/2010 - 20:17 | 418378 New_Meat
New_Meat's picture

Too late for s/w changes for 2010, but not for 2012.  After all, DoJ squashed the Panthers conviction in Philly for voter intimidation (thanks EriK--doin the Saul work there).

Maybe they can manufacture more voters in the precinct than there are people?

- Ned

Wed, 06/16/2010 - 16:42 | 417970 stopthenewworldorder
stopthenewworldorder's picture

anyone fancy a frontrunning panini?

Wed, 06/16/2010 - 17:42 | 418095 awells
awells's picture

Such big moves in response to event used to be characteristic of thinly traded markets. I think that the premise that HFT enhances liquidity is questionable, whatever else they do.

Fri, 06/18/2010 - 16:12 | 418136 Rick64
Rick64's picture

But with as many as 98 percent of orders placed on Nasdaq cancelled or otherwise unexecuted on a given trading day,

 Seems like a good clue that someone is frontrunning. I think that the lost confidence in the market, is due to the bogus pumpup of the market too.

Wed, 06/16/2010 - 18:47 | 418196 jkruffin
jkruffin's picture

Gee, how in the world do we fix this?   Let's see,  how about banning HFT.

That would be too simple, now wouldn't it.  We don't have anyone in office, nor anyone in a regulatory agency, that is smart enough to look at how easy it is to prevent.

Wed, 06/16/2010 - 18:56 | 418218 Waterfallsparkles
Waterfallsparkles's picture

He is right. Investor confidence will be obliterated.  He is also right tonight on CNBC where he said that HFT will KILL the Market they are trading in.  When Retail Investors pull their Money out of the Market never to return who does Wall Street have to rape?  Only themselves.  Even with 0% interest rates in the Bank at least you have your principal.

The other thought would be to put really low bids in the Market in hopes for a Flash Crash and hope to get hit.  Somewhere around 50% less than the ask.  But do not sell the same day as they may reverse your trade and you would go from a long to a short.

Wed, 06/16/2010 - 19:00 | 418221 Waterfallsparkles
Waterfallsparkles's picture

Also, as I have said in the past it is a hollow market.  No one places bids below or above the bidding because it will give the HFT computer information on your intentions to buy or sell the stock.  Everyone today trades around the Bid Ask price with no Bids above or below.  It becomes a Hollow market like we saw with the flash crash. Trader conditioning since HFT.

Wed, 06/16/2010 - 19:06 | 418236 Boilermaker
Boilermaker's picture

In other late breaking news, shit still stinks.

Wed, 06/16/2010 - 19:13 | 418253 Waterfallsparkles
Waterfallsparkles's picture

In another note it looks like the Big Boy HFT's are trying to KILL the Little HFT Computers.  They are eating themselves.  If your are not a Big Boy HFT you can get killed.  Retail are gone.  They have to eat themselves.

Wed, 06/16/2010 - 20:52 | 418415 virgule
virgule's picture

There is another way.

I don't think fudging trading rules to outsmart smart traders is ever going to make markets better / safer. It's just going to make a dangerous market appear to be safe - but it won't change anything about hidden/unknown risks.

Instead, sticking to plain old fashioned trading would overcome all HFT problems AND give regular traders small opportunities for payback from HFT:

- take a position in the stocks you believe in

- don't use any leverage

- no margin calls during massive HFT drops (works on rises too, if your position is short but not naked short ;-)

- plenty of reserve capital to buy at huge discount

It's the greed of leveraging that is killing victims of HFT - not HFT itself.

Wed, 06/16/2010 - 23:13 | 418644 TexDenim
TexDenim's picture

Why does high volatility automatically equal lack of market credibility?

Thu, 06/17/2010 - 00:12 | 418739 StychoKiller
StychoKiller's picture

"In the aftermath of May 6th, the integrity of our markets has been questioned, and investor confidence has been shaken."

Shaken, stirred and frapped!  Sorry, but I'm NOT gonna buy into this mess again.

Like so many knowledgeable people have said before (Peter Lynch, for example): "Don't buy into a business you don't understand."

Thu, 06/17/2010 - 07:33 | 419013 Grand Supercycle
Grand Supercycle's picture

 

EURO bullish warnings mentioned earlier, have strengthened today. Vice versa for the USD index of course.

I have detected EURO buying support for several weeks now.

XAUEUR daily chart gives bearish warnings as of today.

This could be an important development.

The proprietary indicators I use in my technical analysis can identify trend changes before they occur.

http://stockmarket618.wordpress.com

Do NOT follow this link or you will be banned from the site!