Subject: File No. S7-02-10
From: R T Leuchtkafer

May 27, 2010

We should all congratulate the SEC on its recently released report, "Preliminary Findings Regarding the Market Events of May 6, 2010." The report is detailed, honest and frank. Most impressive, the report is quite clear about what is known and what is as yet unknown, and this in the face of enormous pressure to reach a conclusion. I can't think of another example of a federal agency moving so quickly to provide so much data and analysis about such a complex event. And after preparing the report, the agency ate its own cooking on transparency and immediately posted the report front and center on its web site, come what may.

The Shadow Liquidity System

The day after the flash crash, Paul Kedrosky coined the term "shadow liquidity system." It was the shadow liquidity system I attempted to describe in my April 16 comment on the "Concept Release on Equity Market Structure." While not definite, it's becoming clear the shadow liquidity system failed on May 6, and in the wake of its failure we suffered a $1 trillion loss in seven minutes.

I used to think it was ungraceful to quote yourself, but after reading Professor James Angel's latest comment on the Concept Release it seems quite sophisticated, even at length, so I'll do it too. In my April 16, 2010 comment on the Concept Release ( I described how market centers in the last 10 years had engineered "the replacement of formal and regulated intermediaries with informal and unregulated intermediaries" creating a "HFT-dominated market structure and business model that functionally replaced that of the 20th century exchanges." I noted that "A HFT market making firm does not need to register as a market maker on any exchange" and that "market centers pay these firms for supplying liquidity and the liquidity they supply becomes part of the market center business models." Even registered market makers "have little or none of the regulatory oversight" they used to have, and "do not have any meaningful restriction on moving the market, they have no meaningful capital adequacy standards, no obligation to yield to customer orders, no meaningful obligation to maintain competitive quotes, no dealer position monitoring, nothing." In consequence, "The result is that firms are free to trade as aggressively or passively as they like or to disappear from the market altogether." But "They still get valuable privileges if they register as market makers, and they promise in return to merely post any quote, and a penny bid can count as a valid quote." Finally, I wrote that when markets face liquidity demands their behavior can "increase spreads and price volatility and savage investor confidence" and "the public pays the price of the volatility they create," but I didn't predict a massive failure such as that we suffered on May 6, when scores of stocks and ETFs traded at those penny bids.

One of the few who warned of a catastrophe, Professor Angel predicted a massive failure when he cautioned about a "big glitch" and suggested several causes for the glitch - "a runaway algo," "'fat fingers,'" "machine meltdowns" - and warned "billions of dollars of damages could occur." There could have been glitches that exacerbated selling on May 6, but May 6 wasn't just a bug, it was a feature. It was a feature of the shadow liquidity system, of "highly distributed, fully automated and nominally disintermediated marketplaces," as I wrote on April 16. After the flash crash, The Wall Street Journal quoted Dave Cummings, founder of the BATS exchange and of the HFT firm Tradebot, as saying Tradebot withdrew all of its liquidity from the markets on May 6 because "That's what we do for safety." On its web site, Tradebot writes "In the past 10 years, their regulated intermediaries role has largely been replaced by sophisticated high-speed computer models...Each trading day, our algorithms analyze the market data and send millions of limit orders into the market. These limit orders often tighten the bid/ask spread paid by long-term investors." So what happens if, as Cummings said to the Journal, "the market's weird"? They run for the hills. The Journal wrote, "Tradebot's system is designed to stop trading when the market becomes too volatile." We could shout j'accuse but we already have a full confession.

Reviewing the comment letters on the Concept Release, the conventional wisdom before May 6 was, as Professor Angel wrote on April 30 (and apart from his call for circuit breakers), "High frequency technology has not led to high frequency volatility," and near universal praise for the "current high quality of the equity market," as he also wrote. Calls for reform of the most fundamental functions of our equity markets - price and liquidity formation - were few and far between. The conventional wisdom taking shape now is a renewed look at those fundamental functions, and at how regulated liquidity providers have been replaced by literally or essentially unregulated ones over the last 10 years.

The conventional wisdom is also beginning to entertain some curiosities. It is strange to hear that "reform" should include a ban on stop loss orders, as if the United States equity markets are at risk because Mrs. Betty Johanssen of Red Lake, Minnesota posted a 300 share stop loss order in 3M, or that our equity markets are at risk because of a 200 share market order in Procter and Gamble. If this is where we end up, we will have failed. It will be an admission that since we won't or can't reform the shadow liquidity system, the only idea we have left is to ban even retail-sized unpriced liquidity demands.

Circuit Breakers

The conventional window now also includes single stock circuit breakers. As I commented earlier (sophisticated), single stock circuit breakers may be useful in the same sense in which air bags are useful to Toyotas, but they don't cure sudden acceleration problems. The car still surges and crashes, but with air bags we can hope the occupants are a little more protected when it does. There is urgency to do something because political and economic exigencies demand action circuit breakers are something we can do quickly as we continue to try to understand what happened on May 6. While it increasingly seems clear May 6 was transitory volatility related to or caused by severe market structure defects, we're not sure, but we can deploy the air bag if it happens again.

Several foreign markets have single stock circuit breakers, including (as Professor Angel points out) Germany, and, well, Borat's Kazakhstan, which makes it seem silly to some that we don't. Germany and Kazakhstan also have affirmative obligations for liquidity providers (they also have market orders).

Circuit breakers will be gamed, though, and the implementation deadline for our circuit breakers doesn't allow much time for defensive action, such as surveillance, around their deployment. How will our shadow liquidity system respond to circuit breakers? We don't know. The shadow liquidity system doesn't like uncertainty and doesn't like holding positions, even for five minutes, so one possible outcome may be that many of these participants will struggle mightily to go flat as a stock approaches its circuit breaker, increasing volatility before the air bag goes off, increasing volatility simply because the air bag will go off this is the so-called gravitational or magnet effect of circuit breakers, and suggests that more stocks will move 10% after circuit breakers are implemented than before. Stocks might well accelerate into circuit breakers, in other words. And just as it will be interesting to see how the shadow liquidity system behaves in front of circuit breaker thresholds, it will be interesting to see how it behaves after a circuit breaker expires. That is, how will the shadow liquidity system game opening auctions, and how will it participate when trading resumes? No one knows, though there is evidence from an October, 1997 market break that, other than regulated liquidity providers, liquidity dries up after a circuit breaker. Admittedly, that was a long time ago, and the 1997 circuit breaker was market wide, not single stock.

We should worry about deploying single stock circuit breakers before first ensuring we have meaningfully regulated liquidity providers, a risky but perhaps unavoidable experiment. I hope the SEC can release a preliminary study a few months into the experiment, evaluating price velocities going into circuit breakers and liquidity formation during and immediately after them, and comparing this data against data for stocks moving close to and more than 10% before circuit breakers were implemented. Even better would be for the SEC to open a new page on its web site called "Data" and post data for everyone to review.

(Also posted as a comment on the Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues.)