No. of Recommendations: 104
Yesterday (10/1/10) the SEC and the CFTC issued their report on the 5/6/10 Flash Crash. It is 104 pages with lots of pretty multicolor charts that illustrate various aspects of the crash. After reading the report over, I started to write up the most essential points and post them. After further reflection, I decided that the SEC report and my summary of it were almost totally misguided.

Link to the SEC report:

Factually, the SEC report is quite good and comprehensive in explaining various aspects of the crash. For the small minority of investors in America that enjoy learning about nitty-gritty details of what occurred that day, it is a worthwhile read. Exactly how many investors fit into that category? Let’s make an estimate. Let’s assume that 100 investors read the METAR board postings on a regular basis and would take the time to read the full 104 page report. How many non-METARites do you know that would be interested enough to read the report? I don’t see many hands. There are approximately 114 million US households. Let’s assume that half of them either have stock accounts, 401K accounts or some other interest in US equity markets. That gives us 57 million investors that “care” how US equities perform. (Yes, for purposes of simplification, I am assuming there is only one interested investor per household.)

Out of the 57 million investors, how many METAR like investors are there that will read the SEC flash crash report? Let’s be incredibly generous and say 1 million. I actually think it is closer to zero, but let’s assume it is 1 million. That leaves us with 56 million US investors that will only see news headlines on the SEC Flash Crash report.

My original summary was intended for the 100 METARites which I decided was the wrong approach. This new summary is intended for the 56 million non-METARites. Here goes:

1) The SEC totally, 100% missed the most important points to highlight to the masses. Most likely they did this on purpose to try and convince the masses that all is well or will be well with US equity markets. I do NOT think the SEC is so incompetent that they actually believe this to be true, but they have to put a positive spin on it. And no, it is NOT a Democrat or Republican issue. Chris Cox under Bush is the same as Mary Schapiro under Obama in this regard.

2) The SEC lays primary blame for the flash crash on Waddell-Reed placing orders to sell short 75,000 e-mini SP500 contracts. The contracts have a nominal value of $4.1 billion which is supposed to impress the naïve that it is a large number. In fact, on a typical day about 2 MILLION of these contracts change hands. So the 75,000 represent about 3.75% of average trading. Does anybody believe that an incremental change of 3.75% volume should crash the US equity markets? I don’t think so. Similar trades to this likely have been done hundreds of times before without causing a flash crash.

3) Waddell-Reed is basically a widows and orphans mutual fund manager that was trying to hedge an $81 billion equity position. So it is not like they were some wild eyed speculator using 100 to 1 leverage or doing naked shorting. What they were doing was 100% legal, 100% moral, 100% rational and probably prudent.

4) The SEC report should have come out directly and said they every single firm and exchange they investigated was acting legally, morally and rationally in their own self interest. The SEC did not directly say it, but the implication to the public is that Waddell-Reed is somehow the bad guy in the flash crash. ABSOLUTELY NOT TRUE. In fact, what the SEC should have said to the public was that there were NO bad actors involved at all. The markets were working 100% like people intended them to work. Nothing irrational about them at all.

5) The SEC did NOT lay out a definitive action plan to prevent another flash crash from occurring. The reason for this is simple. They have NO plan. The markets have changed dramatically in structure over the last decade or so. In the “old days” when all trades were physically done on the NYSE, you could easily have fixed a problem if it occurred in the markets.

6) These days, there are countless exchanges and “dark pools” where trading occurs. The NYSE specialists are now called “designated market makers.” In the old days, they single handedly had responsibility for maintaining an “orderly market” in issues there were responsible for. These days, there are really NO substitutes for specialists. The High Frequency Traders fill that role some of the time, but as we learned during the flash crash, they can and will simply stop trading if they feel it is in their best interest. Even if the Designated Market Maker wanted to maintain an orderly market, how can he do it on the non-NYSE exchanges and dark pools?

7) The SEC did get one aspect correct. Trading is best described as a marginally stable system. What we learned is that it is relatively easy to have the system go unstable and out of control. Think of a jet fighter flying 100 feet off the ground at Mach 1. If something goes wrong, you get a large earth crater in a few milliseconds. That is kind of what our markets have evolved to. Incredibly high speeds with not much margin for error.

8) If the SEC was honest and upfront with the masses, here is what they would say. “Welcome to 2010. This is how markets now work. We can not reasonably guarantee another flash crash will be prevented. Matter of fact, we suggest you plan on them as a normal part of the investing landscape. But don’t worry, we believe they have NO long term impact on the fundamentals of equity investing. If stocks irrationally flash crash again, they will shortly go back to their correct, rational prices.”

9) As a practical matter, I don’t know how to put the genie of “stable” markets back into the bottle. While it is theoretically possible to do, there is so much money involved, I can’t imagine rolling back the clock. Stated differently: “Dorothy, we are NOT in Kansas anymore. Tapping your ruby red slippers together three times will NOT take us back to the stable markets of Kansas.”

As you can see, my message on the Flash Crash aimed at the 56 million non METARite investors would deliver a very different message than what the SEC did.

If anyone is interested in technical nitty gritty details of the flash crash, I will publish that summary. However, after reflecting for a while, I think it is less pertinent than this summary. There is one other aspect that has changed since the flash crash. If someone wanted to use lets call them questionable techniques to game the market, it is a lot more obvious how to do it after all of the flash crash research came out. I have to think that enterprising investors are hard at work figuring our how they will use these to increase profits at any available opportunity. . .


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