Ted Kaufman - United States Senator for Delaware

A Market Solution That Put Investors in a Fix

Source: Wall Street Journal

By Dennis K. Berman

August 24, 2010

They thought they were saving the stock market. They ended up maiming it.

The May 6 "flash crash" was the culmination of 35 years of relentless stock-market reform, much of it rightly making the markets cheaper and faster, largely free from the 20th-century market makers who feasted on huge trading spreads and occasional chicanery.

Yet somehow we have wound up right where we began: with a market that many perceive as tainted and prone to gaming by a cadre of insiders. Only this time, instead of wielding the biggest, baddest berth on the New York Stock Exchange floor, they are wielding the biggest, baddest computers.

When BlackRock Inc. surveyed 380 financial advisers earlier this summer about the flash crash, their perceptions said it all: The mayhem had been primarily caused by an "overreliance on computer systems and some types of high frequency trading" strategies that roam the market en masse, looking to pick off pennies of profit.

Today, small investors are fleeing the equities markets in droves, according to data from the Investment Company Institute, pulling out a net $34 billion from stock funds so far this year. Bigger institutional investors, says Justin Schack, vice president of market-structure analysis at New York brokerage Rosenblatt Securities, are suspicious.

They say, "I still feel like someone is screwing me,"' Mr. Schack adds. Even though they have benefitted from shrinking trading costs, he says, "trading feels different than it used to."

In coming weeks, the Securities and Exchange Commission and Commodity Futures Trading Commission are expected to release their report on the frantic hours of May 6. No doubt their work will home in on the so-far inscrutable interplay between myriad exchanges and high-frequency traders, whose volume now accounts for an estimated two-thirds of all trading.

The irony is that this is the system both Congress and the SEC worked decades to set up: competitive and "flat," shorn of hierarchy, where trades are routed to the best price on any open market and commissions are relentlessly squeezed.

Behind these changes, beginning in 1975, was a zeal to liberate the individual investor from the clutches of the archaic market makers who made a good living taking "eighths"—12.5 cents—for every share bought and sold.

The government later found Nasdaq dealers were even more gluttonous than first imagined. And by the time the last big market reforms were issued in 2005, the intent was to "give investors, particularly retail investors, greater confidence that they will be treated fairly," the SEC said at the time.

As spreads squeezed from eighths to pennies, a new batch of electronic-trading networks blinked into action. Volume trading was the only way to make money.

Saving money has taken its own toll. The market has become deeply fragmented, traded across at least 50 trading venues both large and small. Those high-frequency traders now making the markets have only the option—and not the responsibility—to step in at a time of distress like the flash crash.

In other words, we have traded cheaper up-front costs for unknown back-end ones. That is exactly what is spooking the same investors the SEC vowed to protect in 2005.

In an Aug. 5 letter to SEC Chairman Mary Schapiro, Sen. Edward E. KAUFMAN (D., Del.) said it might be best for market stability if the SEC "empirically challenge[d] the mantra that investors are best served by narrow spreads." Asking such heretical questions is required as Washington grapples with how to restore confidence in the U.S. markets.

Just don't expect a cure-all.

"The market always tries to find its way around the rules," says Vanderbilt University's William Christie, whose work first exposed the game-playing among Nasdaq dealers in the 1990s. "It's kind of like a balloon—you squish one side and it pops out the other."

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