May 6th Market Crash - Rage Against The Machine, Or the Human?

May 7, 2010 12:13 PM EDT
Instead of "fat finger" trades, hackers or bad prints, it appears much of yesterday's nearly 1,000 point intra-day market crash was created by a lack of bids and efficiency, which created a vacuum and a subsequent panic.

First the markets started weak with the riots in Greece plastered all over CNBC. This selling pressure was normal and orderly. But after 2:30PM selling picked-up and key technical levels started to be taken out. Seeing this action, market players (both human and computer) dropped their bids and moved to reduce risk. Due to the lack of bids, even small orders could move stocks down significantly. The selling cascaded, leading to more selling and more dropping of bids.

With the selling panic, circuit breakers on individual stocks were triggered on the NYSE. As orders were routed to the NYSE they weren't being accepted for 90 seconds. This led to trades being routed away from the primary market to other exchanges like NASDAQ. Since these markets were far less liquid, price drops were viscous.

Procter & Gamble Co. (NYSE: PG) traded through electronic exchanges as low at $39.37 yesterday, but the NYSE said the low there was just below $60 due to the circuit breakers. Some stocks like Accenture plc (NYSE: ACN) executed trades at prices as low as $0.01 off the NYSE. Now Nasdaq will cancel all trades executed between 14:40:00 and 15:00:00 greater than or less than 60% away from the consolidated last print in that security at 14:40:00 or immediately prior.

Yesterday's wild action has traders, investors, and the exchanges themselves calling for changes.

One solution that was brought up by NASDAQ (Nasdaq: NDAQ) CEO Bob Greifeld is to create system-wide circuit breakers. So when a circuit breaker triggers on an individual stock on the NYSE, it triggers on all the exchanges.

Another item investors and traders may want to keep an eye is the upcoming implementation of the "alternative uptick rule", which is designed to stop price declines of 10 percent or more by limiting short selling. Under the new rule, once the circuit breaker is triggered, short selling would be permitted if the price of the security is above the current national best bid. The effective date for the alternative uptick rule is May 10th, and market participants will have six months to comply with the requirements once it is effective.

If the rule would have been in place yesterday, could that have saved the market from the nearly 1,000 point crash? This can be debated. In favor of the rule, it could be argued that that shorts would not have been permitted to "hit the bid" on already weak stocks. Against the rule, it could be argued that this will create further illiquidity and fewer bids (shorts eventually have to buy stocks back that they short).

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