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Features May 20, 2010, 5:00PM EST

The Machines That Ate the Market

(page 2 of 5)

Sell orders piled up much faster than buys, an imbalance that worsened over the next hour. During the period of heaviest selling, starting around 2:30 p.m., the NYSE paused electronic trading in certain stocks and switched to computerized auctions conducted by human traders. This caused electronic sell orders to be rerouted to other trading venues, where there were few, if any, buy orders to absorb them. As Mary L. Schapiro, chairman of the Securities & Exchange Commission, put it in congressional testimony five days later, some high-frequency firms "withdrew their liquidity after prices declined rapidly."

During the next few hours of confusion, exchanges began canceling trades in hundreds of stocks. NYSE Arca, an electronic platform operated by the Big Board, erased transactions in 295 companies. A surge in trades rejected by exchanges constitutes another trigger that automatically causes some high-frequency firms to slow down, says Ethan Kahn, a principal at Wolverine Trading, an electronic market-making outfit in Chicago: "You disable. You shut down." Wolverine pared back activity in equity futures because of concerns about the accuracy of data it was receiving, he adds.

In Washington, the staff at the SEC began reviewing up to 10 terabytes of market data to figure out what happened. Twelve days later, on May 18, the agency conceded that it still couldn't offer a firm answer. That uncertainty in itself suggests the disquieting complexity the stock market now presents.

The SEC and the Commodity Futures Trading Commission issued a preliminary report in which they outlined six hypotheses that could explain the scare. "We continue to believe that the market disruption of May 6 was exacerbated by disparate trading rules and conventions across the exchanges," Schapiro said upon the report's release. As one response, the SEC proposed that exchanges halt trading in individual stocks that swing more than 10 percent during a five-minute period. The new "circuit breaker" rules are subject to commission approval after 10 days of public comment.

While temporarily slowing trading during periods of investor high anxiety makes sense to regulators, at least some high-frequency traders disagree. "I don't think that's the right solution," Wolverine's Kahn told Bloomberg News after the SEC announcement. "It could cause a lot of complications. On a busy day where the market is making major moves, you'd have a handful of [stock] names where it's circuit breaker-on/circuit breaker-off all day."

As this debate unfolds, one danger is that regulators, politicians, and industry executives—already distracted by how to reform Wall Street in the wake of the broader credit crisis of 2008—will shrug off May 6 as a weird blip requiring no fundamental rethinking of how man, machine, and market interact. Absent so far from the public discussion is any talk about whether the next quickie-crash might coincide with an outside event that shakes investor confidence much more severely: Iran and its nukes, industrial-environmental disaster, North Korean aggression. Or all of the above.

As we just saw when major investment banks suffered blindness to the toxic effects of mammoth leverage, exotic credit derivatives, and a nationwide housing bust, Wall Street's computer models tend to fail when unpredictable disasters overlap.

For generations, the Big Board played the vital role of estab- lishing prices for most major stocks. Even after rudimentary computers arrived in the 1960s, living, breathing people continued to supervise the proceedings. Beginning in the 1970s, Nasdaq, and, later, additional electronic rivals, gradually eroded the NYSE's dominance. Humans could intervene if things got too strange.

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