In the wake of the May 6th flash crash, senior managers gathered in the war room at the Securities and Exchange Commission. The mood was tense. A few days earlier, the Dow dropped almost a thousand points in a few minutes and scared the pants off the financial world. The SEC was completely blindsided. The media were demanding answers and wanted them yesterday. In the room was a broad spectrum of disciplines and backgrounds including a securities law specialist (lawyer), an ex-Wall Street executive (wise guy), an ambitious by-the-book regulator (enforcer), and a political operative from the White House (politician). Here are snippets of their conversation.
Politician: “Needless to say, the White House has been inundated with angry phone calls and emails wanting to know what caused the flash crash. The Press Secretary is doing his level best trying to deflect questions from the media but he cannot hold them off forever. Our fragile economic recovery cannot withstand such perturbations. We need answers and we need them quickly. What the hell happened?”
Lawyer: “The SEC has convened a board of inquiry to investigate the matter. We have early indications that a large sell order from a firm in Kansas caused a trading imbalance, which precipitated a temporary dislocation in market activity.”
Enforcer: “We know much more than that. Our people have known for years that the unbridled growth of unregulated high frequency algorithmic (HFA) trading has created conditions that were ripe for the type of crash that occurred on May 6th. It was an accident waiting to happen and still is. We believe that traders are using HFA trading and computers to game the market each and every day through market manipulation. One just has to look the consecutive string of statistically impossible, profitable trading days to know they are bilking investors. Yet we are told to stand down. High frequency trading is off-limits. For chrissake, we still haven’t banned flash trading, which is the very definition of cheating. It’s almost like HFA trading is too-big-to-bust.”
Wise Guy: “Listen, these unfounded accusations simply feed into a frenzied paranoia among investors, which itself unsettles the market. High frequency trading provides needed liquidity to our capital markets by narrowing the spread between bid and ask prices. Everyone benefits.”
Enforcer: “Yeah, everyone on Wall Street. Any perceived narrowing between bid and ask prices is gobbled up by HFA traders who manipulate prices higher. Investors pay more for their shares and the HFA traders bag the difference. It is tantamount to an undeclared tax on each transaction. The so-called liquidity that HFA trading creates is ephemeral and will flee the market in a heartbeat just as it did a few days ago when a trading imbalance was detected. When that happens, the market crashes. It can happen at any time and next time it may not be a temporary phenomenon. With control of 70% of the volume, HFA traders have effectively cornered the market.”
Wise Guy: “That is sheer alarmist rhetoric and has no place in this discussion. HFA trading has been going on for years and now you are suggesting that we shut it down. We will be run right out of town for gross incompetence.”
Politician: “Gentlemen, can we stay on topic? First, we need a thorough examination of what occurred during the flash crash event and why it happened. Second, the White House is deeply concerned that this might happen again. If so, it wants to be prepared.”
Lawyer: “That is exactly why we have enlisted the services of Wall Street experts to assist us in our investigation. After all, who is better equipped to explain the intricacies of high frequency trading and how it reacts under such conditions?”
Wise Guy: “Excellent move.”
Enforcer: “So let me understand this. We are going to have the fox help us investigate the break into the hen house? The SEC is perfectly capable of tracking trade and tape information to determine exactly what occurred and why it occurred. It would be easy for us to prove that these firms are using algorithms to manipulate the markets to their advantage. We can also determine exactly how this type of activity makes our capital markets vulnerable to a crash during a dislocation. The integrity of the marketplace is at stake. If we have to, we can shut down HFA trading before it too late.”
Wise Guy: “That kind of talk is insane and irresponsible. It sounds like you have made up your mind without one shred of evidence of any wrongdoing.”
Politician: “O.K. Let’s get to bottom of the flash crash first. It is perfectly reasonable to have Wall Street experts assist in the investigation because they can offer resources and expertise that we lack, especially as it relates to such complicated trading activities. When can we expect a draft report on this matter?”
Lawyer: “It will take a few months. In the interim, the SEC has decided that the installation of pilot circuit breakers on our exchanges should be sufficient to mitigate and limit any exposure to another flash crash, if one should recur. After our report is delivered, we will convene a committee to look into HFA trading activities in more depth to determine whether any further action is necessary.”
Enforcer: “I do not detect any sense of urgency. Am I correct?”
Politician: “This meeting is adjourned. In the meantime, it is business as usual. Frontline regulators shall take no further action on this issue until we receive the final report and review its recommendations.”
Such is life at the SEC. The delicate matter is left in the capable hands of a politician, a lawyer, and a wise guy, all of whom represent the interests of Wall Street. The enforcer is told to back down because he is not a team player. He does not understand that the wise guys always win.
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