Adjusting the arcane rules governing exchange trading execution will not remedy broader financial-system problems and global macroeconomic mismanagement that are producing a new wave of volatility in the world's securities markets.
Volatility in the world's stock markets has increased again since the end of April, after about six months of relative tranquility. In this environment, and with the memory of 2007-08, investors and regulators are wary of the possibility of unexpected market moves snowballing into large and unforeseen declines.
A symptom is the 'flash crash' on 6 May 2010, when the US stock market fell just over 1,000 points and rebounded from the decline, all within minutes. The total decline during the flash crash amounted to 9 percent, including 7 percent within a quarter-hour.
Sources of volatility
Rumors of human trading error were fairly quickly discounted, and attention focused on the possibility that unanticipated sequences of cascading automated trades were at the origin of the flash crash. Close inspection of the trading record after the fact revealed that prices of some stocks reportedly fell to the 'stub value' of one cent (a value used merely as a place-holder and never intended actually to be quoted much less executed) while that of others increased to over $100,000.
Some observers have assigned blame to the repeal of the so-called uptick rule on 6 July 2007, just weeks before the financial crisis broke out with well-known results for the stock markets. Introduced in 1934 and implemented in 1938, the uptick rule applies to so-called short sales, which are sales of stock borrowed by an investor who borrows expecting to be able to 'cover the short' (i.e. buy the underlying stock necessary to 'cover' the sale) at a lower price in the future. The uptick rule basically required that the price paid for borrowed stock and short sale had to be higher than the currently bid price.
The purpose of the rule was to prevent short sellers from accelerating the downward momentum of a declining stock by saying they would sell their borrowed stock at a price already lower than the current price. By requiring that short sale orders be entered with a price above the current bid, market regulators make certain that the order is filled on an uptick. Critics of the rule's repeal assert that it came at the wrong time and was in any case ill-advised, as the rule's revocation removed the incentive not the 'pile on' a declining stock, driving it into an abysmal price vortex.
A symptom, not the illness
Thus Yaneer Bar-Yam, president of the New England Complex Systems Institute, tells ISN Security Watch that the uptick rule "protect[ed] the markets from extreme downward price spikes in times of uncertainty" and that its repeal was "a key component of decreased market stability and vulnerability."
Bar-Yam's Institute has completed a number of careful studies of the market's behavior and of that of individual stocks in the periods before, during and after the 'flash crash', and he has consulted with Congressional committees on the technical aspects of the problem. While not blaming the 'flash crash' directly and solely on the repeal of the uptick rule, Bar-Yam noted that unstable markets that are not "seen as being in equilibrium … [can] undermine investor confidence."
Indeed, trading curbs called 'circuit breakers' have since been experimentally applied so as to institute a five-minute halt in trading in any stock in the S&P 500 index that changes in value by 10 percent within any five-minute period. These circuit breakers have already been flipped automatically in several cases, leading critics to assert that the basic problem of flash crashes has not been resolved. Bar-Yam calls the circuit-breaker idea an "after-the-fact band-aid" that only covers over underlying instabilities, because circuit breakers are an admission that the markets function poorly: they merely stop the markets from operating.
Re-instating the uptick rule may not solve every problem involving electronic markets and rapid trading, Bar-Yam says, but it would be an important step towards re-establishing market stability. Indeed, the flash crash was only a particular manifestation of the increased volatility that has characterized the equity and financial markets since the outbreak of the global financial crisis in 2007-08.
The real problem
That volatility arises from underlying problems of management of the international financial system. It is exacerbated by the programmed nature of many financial transactions and the lack of transparency around some of the most sensitive financial instruments. These elements in turn complicate any attempt even to understand the nature of the dynamics at work, and so also any attempt to ameliorate their consequences. The US and European financial crisis became a global phenomenon because banks stopped lending to each other. This interbank lending crisis was driven by the fact that the institutions concerned did not know the real values of their most arcane derivative holdings, consequently did not know the values of other institutions' assets, and as a result conserved their own.
Interbank lending represents the nerves of the financial system. As governments acted to bail out their financial services sectors, this situation turned into a government debt crisis. The problems in Greece came to the fore, and the failure of Brussels to address that matter in a timely fashion only made the situation worse. Consequently, the national accounts of Spain and other EU members are perceived to be at risk, and the entire euro zone has been weakened.
Moreover, market volatility has accelerated in recent weeks even in Asia. The risk of unexpected volatility, of which the flash crash was only a symptom, will endure for so long as opaque and thinly traded financial instruments (some of them with prices quoted only in emails narrowly distributed among desks in the principal financial houses) continue to drive real markets rather than acting as stabilizers: for those instruments are the 'unknown unknowns' of which even professional analysts are only murkily aware and which have therefore unforeseeable effects at unforeseeable times upon the behavior of the global financial system as a whole.
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First published by ISN Security Watch, 9 July 2010.