Gone in a flash: The life savings of millions of Americans could disappear in an instant and the SEC has no idea what to do about it

Joe Tauke Contributor
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On May 6, the Dow plunged hundreds of points in a matter of minutes for reasons that most investors couldn’t explain. Amazingly, even as Jim Cramer was melting down live on CNBC, the market zoomed right back up just as quickly, leaving everyone, including the SEC, to wonder what had just happened. The incident has become known as the “flash crash” in investment circles.

“I don’t think anyone is sure what caused it,” Professor Craig Pirrong of the University of Houston told The Daily Caller. “And the SEC’s explanation has been underwhelming, to say the least.”

Most people think that there hasn’t been a flash crash since that day, but that’s not entirely true. There hasn’t been a flash crash in the entire market since that day. There have, however, been flash crashes in individual stocks, including Intel, Seagate Technology, and Progress Energy. Each has experienced a sudden and massive price drop, followed by an equally sudden and massive increase in price. The phenomenon persisted throughout the summer, and has happened within the past month. Active traders who lost their shirts by selling at the wrong time were left wondering what mysterious force was causing these crashes.

The SEC has offered one set of answers in a report released last Friday. The agency has decided to cling to the same explanation it offered shortly after the original flash crash — that the mysterious force was a small investment company in Kansas named Waddell & Reed Financial.

By selling more S&P 500 futures contracts than usual, Waddell caused enough investors to sell in a panic to cause a crash, or so the story goes. As prices fell, automated trading performed by computers sold more, sometimes on behalf of investors who had put in “stop-loss” orders, which are orders to automatically sell a stock if it falls to a certain price. But when the stock is falling faster than the stop-loss order can be activated, the losses aren’t prevented. The SEC’s earlier report on the crash said that stop-loss orders accounted for between 70% and 90% of all orders attempting to sell stocks that had fallen to the price of a penny or near a penny.

So far, the SEC’s main recourse has been to void some of the orders made in error. Investors simply have to hope that the same agency that blames the incident on a firm in Kansas correctly identifies their orders as the ones that were made erroneously. They also have to hope that they’re not induced to sell at a loss due to unease generated by the flash crash. Every single week since the event has seen net selling by equity mutual fund accounts, even during the recent rally. Some of those sales have been made after purchases at the highs of the tech bubble or housing bubble.

Moreover, the SEC’s explanation contains no understanding whatsoever of the cause of flash crashes in individual stocks. The issue is simply ignored, at the peril of anyone who lost big during those crashes.

The media reaction to the SEC report is perhaps best summarized by a Forbes blog headline, “Waddell & Reed Also Kidnapped the Lindbergh Baby, Shot JR Ewing.” To say that some investors are skeptical would be kind. The Forbes blog post goes on to compare the May 6 flash crash to the Great Chicago Fire, which was “caused” by a cow kicking over a lantern but was actually so destructive because Chicago buildings were a bunch of kindling stacked on top of each other. Blaming the cow misses the point.

A different trading commentary site, The Market Ticker, also notes that Waddell’s action was to sell 75,000 futures contracts, and just last Friday 71,573 of the same contracts were sold in the last minute before the New York stock markets rang their bells. No flash crash occurred, either in regular market activity or after-market activity.

The SEC’s failure to truly assess the problem is highlighted by an exchange between TheDC and an SEC representative. When asked what the SEC’s plan to prevent flash crashes in individual stocks was, the representative responded by saying that he didn’t know what the question was referring to.

The representative also pointed to a September 22 speech by SEC Chairman Mary Schapiro, in which she stated that the SEC plans to investigate the origins of the flash crash. Yet the representative said the speech was the first place to look for answers to questions about flash crashes in general. Apparently the answers are to plan for planning.

The SEC report also claims that as the market crashed, computers using algorithms to execute trades in fractions of a second stopped buying, and the loss of that purchasing power reinforced the crash. But the SEC has also argued that those same computers, performing what is known as high-frequency trading, also provide vital liquidity to the market. “Liquidity” is a term for money being used to buy anything being sold, and is reflected in the market’s ability to absorb a large sell order without a large change in prices — which is exactly what didn’t happen during the flash crash.

A more accurate analysis, then, would state that high-frequency trading provides liquidity, unless it doesn’t. And if the markets can react so violently to someone merely flicking the off switch on the HFT computers looking to buy, then any American could find themselves playing the role of Randolph and Mortimer Duke, bankrupt and frantically shouting, “Turn those machines back on!”

“I didn’t see anything in the SEC report which suggested that the SEC has figured out how to prevent flash crash losses,” said Pirrong, who went on to make nearly the exact same analogy made by Forbes. “It’s like a huge fire caused by striking a match. The SEC should be figuring out why there was so much kindling, not why the match was struck.”

Pirrong pointed out that the SEC report acknowledged the lack of liquidity in the market during the flash crash, but contained no legitimate explanation of that problem. “What’s most disappointing is that the SEC didn’t explain why worries about Greek debt and general unease about the economy haven’t caused other flash crashes,” he said. “The market has been concerned about those issues at other times.”

What’s the SEC remedy for the flash crashes which have happened in those other times? Plan for planning, and hope you’re one of the lucky people whose orders are canceled — which only deprives someone else of profits. Protection for losses taken due to the fact that computers have been making trades that investors don’t actually want to make simply doesn’t exist.