US House Committee fails to find smoking gun on market plunge

Wild plunge of last week adds greater urgency for the SEC to stem market swings

The U.S. House of Representatives Financial Services Subcommittee on Capital Markets failed to pinpoint any single cause for last week's stock market plummet that sent the Dow Jones Industrial Index plunging almost 1,000 points in a half hour.

The committee held several hearings on Tuesday , during which members questioned the heads of the U.S. Securities and Exchange Commission, New York Stock Exchange and Nasdaq in an attempt to gain some insight on what caused the precipitous drop.

The Dow fell to 9,872 points in a half hour last Thursday. As quickly as the market dropped, it suddenly and dramatically reversed itself, recovering 543 points in approximately a minute and a half, to 10,415.65, and ended the day down 347.80 points from the previous day's close.

SEC Chairman Mary Schapiro told the committee she was "committed to finding effective solutions in the very near term," and also said an existing agreement with major exchanges was in the process of strengthening trading restraints with regards to big market fluctuations.

"The events of last week are unacceptable. The SEC is engaging in a comprehensive review and will take necessary steps to implement additional safeguards to prevent the type of unusual trading activity that occurred briefly last week," she told the committee.

Committee Chairman Paul Kanjorski (D-Penn.) said that after hearing the testimony from the SEC, he felt "a lot more secure."

Not everyone on the committee echoed that sentiment. Schapiro said the market had already declined 161 points, by 2:00 p.m. over the financial meltdown in Greece, uncertainty surrounding elections in the United Kingdom, and an upcoming jobs report.

"Shortly after 2:30 p.m., however, the market decline began to steepen and, by 2:42 p.m., the DJIA was at 10,445.84, representing a decline of approximately 3.9%. The DJIA then suddenly dropped an additional 573.27 points, representing an additional 5.49% decline, in just the next five minutes of trading, hitting 9,872.57 at 2:47 p.m., for a total drop of 9.16% from the previous day's close," she said.

Industry experts said it was obvious that there was some sort of "algorithmic error" in the computerized trading systems that caused the pricing in the markets to collapse.

Some blamed the anomaly on a trader attempting to short-sell 16 million shares of S&P 500 stock, but instead of entering a "m" for million, he entered a "b" for billion. That error allegedly sent high frequency traders scurrying, causing liquidity to vanish.

"While we cannot yet definitely rule that possibility out, neither our review nor reviews by the relevant exchanges and market participants have uncovered such an error," Schapiro testified.

Whatever the error, experts have said it was very likely exacerbated by a market made more volatile by high-speed trades and automatic sale orders that are measured in milliseconds , instead of seconds or minutes with a manual system.

Earlier this year, the SEC sent a letter to brokerage houses saying it was conducting a "broad review" of the equity market structure and asking them for comments. The review would include an evaluation of equity market structure performance in recent years and an assessment of whether market structure rules have kept pace with, among other things, trading technology.

The SEC asked for comment on a wide range of issues, including high frequency trading, order routing, market data linkages, and undisplayed, or "dark," liquidity.

Financial Services Committee ranking member Spencer Bachus (R-Ala.) cautioned against taking action before the reasons for the market drop are clear. Bachus said in a statement that the challenge is to address the problem but at the same time not destroy the benefits of an automated market.

"In my opinion, since January, the SEC has done this. The meeting yesterday with the leading trading platforms followed by the proposed initial corrective action was appropriate. They all acted in a measured way," Bachus said.

Schapiro told the House panel that there is evidence that some firms that had previously been active participants in the markets withdrew their liquidity after prices declined rapidly.

"These firms may have acted appropriately under current rules, as a firm's risk models may have concluded that the action in the market presented too substantial a risk. "We are looking at the data and considering the types of obligations that should apply to certain liquidity providers," she stated.

Schapiro said severe market drops are not exclusively associated with automated trading platforms and have occurred throughout financial market history, including a 22.6% drop on Oct. 19, 1987.

The SEC has already undertaken a number of initiatives to strengthen the integrity the markets, even before last Thursday, Schapiro told the committee.

In February, for example, the Commission adopted a short-sale "circuit breaker," rules designed to limit short selling where an individual stock is under stress and has experienced a decline of 10% from the previous day's close.

"The market events of last Thursday add greater urgency for the Commission to vigorously pursue a number of meaningful initiatives to promote investor confidence in the integrity and fairness of the securities markets, including a number of proposals already underway," Schapiro said.

Lucas Mearian covers storage, disaster recovery and business continuity, financial services infrastructure and health care IT for Computerworld . Follow Lucas on Twitter at @lucasmearian or subscribe to Lucas's RSS feed . His e-mail address is lmearian@computerworld.com .

Read more about financial services in Computerworld's Financial Services Knowledge Center.

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