Would Trading Curbs Make Market Woes Worse?

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Fixing the stock market, it appears, is not as easy as we thought. In the days after the May 6th so-called “flash crash” that sent the market down nearly 1000 points in about 15 minutes, it seemed that everyone agreed on one point: We need better stock market curbs. Halt stocks instead of exchanges and we would never have to worry about stock market drops again, at least not ones that occur while I am out getting lunch (yes, I tend to eat my mid-day meal on the late side). Done and done.

Well it turns out that fix might not be as good as we thought. Here’s why:

Turns out some traders think that curbs might add more volatility to the market, not less. I guess the theory is if you have all these people who want to trade and then you bar the door, yes you could have a cooling off period and some of those people go away. But you could cause the exact opposite result. Instead of the crowd waiting to sell dissipating during the market stop, it could grow. When you throw the market’s doors open again, the crush of selling could be even worse.

Investors have mostly embraced the breakers as necessary given the trying times. Still, a flurry of temporary stoppages could soak up liquidity, impact derivatives markets and make for choppy short-term trading, observers said.

“If you put a bunch of stock gaps in the way, you don’t know what’s going to happen after the gap releases,” said Marc Pado, U.S. market strategist at Cantor Fitzgerald & Co in San Francisco.

“There’s a lot of uncertainty of what happens when you just stop things for five minutes. So a lot of people disagree with it. Some people feel it’s the right way to go, but unfortunately, not knowing what the end result is another risk you take when you invest.”

The SEC’s chairwoman Mary Shapiro told a Senate panel on Thursday that the SEC is committed to trying out the trading curbs, but that she thinks that is not the only solution. She also thinks we need to so something to get more humans back into the market making.

She [SEC's Shapiro] emphasized that one of the most important factors in controlling rapid market plunges is to “get that human factor back into” the markets “when the technology has run amok.”

Gary Gensler, chairman of the U.S. Commodities Futures Trading Commission, agreed that “we need to examine whether further protections are needed in these fast-paced computer-driven markets.”

He added, “We can’t stop technology, but I think we need to update our [regulations] to stay abreast of this.”

That was one of the points I was trying to make in one of my market fix solutions in the article I did two weeks ago.

In the late 1990s, marketmakers would regularly artificially inflate the difference between what a buyer paid for a stock and what a seller got — the so-called spread — in order to boost the marketmakers’ profits. That drove up the cost of trading stocks. In order to stop that, regulators forced the Nasdaq and the NYSE to open up their markets to competition. New electronic exchanges popped up. Spreads narrowed — in many cases to as little as a penny, sometimes less — and that brought down the cost of trading.

It also drove the marketmakers and specialists, who are the people who stand on the floor of the NYSE finding buyers and sellers, out of business. Computers now do much of the function of buying and selling stocks. Most days it works well. On May 6, not so much. Computers, unlike actual marketmakers, will not step in to provide liquidity when stocks plunge. In fact, computer traders have the opposite effect: they all basically move with the tide.

One solution would be to mandate that all stocks have a minimum spread — even a few pennies would make marketmaking more profitable — and give an incentive to specialist firms to buy in and calm the markets.

Widening spreads is probably not a popular solution. And I don’t believe it came up in Thursday’s hearing on the mater. It’s not popular because wider spreads will increase the cost of trading. But if it means eliminating 1,000 point gut wrenching drops that scare individual investors out of the market, then I think it is probably worth the cost.