2 Must-read Articles Examine Stock Market’s Flaws – Picture Is Not Good

Wednesday, September 15, 2010

The flaws in the US stock market that caused the May 6 “flash crash” remain. These two articles bring troubling news.

ARTICLE #1 – Congress hears that the risks include foreign-based market manipulation

How Foreigners Could Disrupt U.S. Markets” (Barron’s, by Jim McTague, September 11).

Similar to foreign computer hacking, only legal, is the ability of offshore traders to access our now-exposed, computer-based stock trading systems.

The potential risks? From profit-seeking price gyrations to widespread disruption.

The risk level? High

“… witnesses before an informal convocation of the House Committee on Homeland Security on July 20 were united in their conviction that the nation’s 10 or so stock exchanges and 50-plus related trading venues are vulnerable to attacks from traders overseas. This is a frightening revelation.”

The cause? The SEC-driven changes that broke apart the previously well-organized stock market exchanges.

Congress’ next steps? Possibly nothing. (Highlights below are mine)

“The full committee hasn’t scheduled a formal hearing on the subject, probably because data on trading from May 6 is so far-flung and incomplete, investigators would be unable to reach a definitive conclusion about foreign interference.”

This admission confirms the unnerving SEC comment made shortly after the flash crash. Namely, that the SEC doesn’t have the data to analyze what happened. In fact, after allowing the US stock exchange trading to become fragmented, the SEC hasn’t had the necessary information to run their computer programs built to ferret out suspicious and unnatural trading.

ARTICLE #2 – The SEC seems to understand the causes, but it might not fix them

SEC Questions Trading Crusade as Market Makers Disappear” (Bloomberg, by Nina Mehta, September 13).

The first five paragraphs provide the meat and show the SEC now knows that its “modern” fragmented-exchange structure is to blame. Importantly, they understand that the New York Stock Exchange (NYSE) specialist system, rather than representing an unfair monopoly, actually produced “true” liquidity – i.e., the buying and selling necessary to maintain a fair and orderly market” and provide liquidity as needed to provide a reasonable quotation [bid/ask]. Those quotes were the NYSE’s specialist requirements.

Now that the SEC says it knows the problems, what is it doing?

Further in the article, SEC Chairman Mary Schapiro explains:

“The SEC is in the ‘early stages of thinking about whether obligations on market makers akin to what used to exist might make sense’…. The issue is ‘whether the firms that effectively act as market makers during normal times should have any obligation to support the market in reasonable ways in tough times’….”

Since the SEC is only in the “early stages of thinking,” we cannot discern where their deliberations might lead. But we can hazard a guess.

Will the SEC admit it was wrong and return to the proven specialist system?

Based on its recent record, it is questionable.

First, four months with little progress. Allowing so much time to pass indicates an improperly low priority on fixing the flaws and/or a desire (hope?) that time will diminish the perceived problem.

Second, the SEC has already said the flash crash wasn’t its fault. See my article, “Wall Street and SEC to Investors: ‘It Wasn’t Us, but We Will Fix It’” (May 12).

Third, the SEC’s reaction to short selling run amok due to the SEC’s rule removals: No mistakes made – therefore, no guilt and no fix

The SEC decisions to first remove the 1930s “uptick” rule and then allow “naked” short selling heightened the waves of panic selling in 2008/2009. The changes, criticized by many on Wall Street, permitted highly disruptive trading tactics, not seen since the 1920s and earlier. The SEC’s reaction? After examining the situation, the SEC found no reason to return to the “old” rules. Instead, it tweaked some circuit breakers, dealing with the symptoms only. So, no admission of making a mistake and no need to take true, corrective actions.

Fourth, the SEC’s preliminary word choice (quoted in the Bloomberg article, above)

“Chairman Mary Schapiro called on the agency last week to examine whether the loss of ‘old specialist obligations’ has hurt investors….”

The use of “old” could again be the SEC’s semantic rationale for neither admitting guilt nor making a proper fix.

So… The US stock market remains flawed and at risk of volatile and even disruptive behavior. As investors, we need not forsake stock investing. Rather, we should take precautions so as not to be overly influenced by the higher volatility or to get ensnared when the system misfires. Below are three articles I have written about steps we can take.

Wall Street Hits Air Pocket – Two Trading Lessons (Part 3)” (May 9).

Trading Strategies for Today’s Markets” (May 13)

Five Stock Market Pictures – Which One Is Right?” (June 18)

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