Gensler Looks For New Rules For Brokers

by Glen Shapiro, LawAndTax-News.com, New York

08 October 2010

Following the official report presenting findings on the causes of the stock market disruption seen on May 6 this year, the Chairman of the United States Commodity Futures Trading Commission (CFTC), Gary Gensler, has looked at whether market brokers should be subject to new rules.

The 'Flash Crash,' as it is called, was an extreme movement in the prices of many US-based equity products that experienced an extraordinarily rapid decline and recovery. For example, it was the biggest point decline on an intraday basis, almost 1,000 points, in the Dow Jones Industrial Average’s history.

The joint report of the Securities and Exchange Commission (SEC) and the CFTC identified the original source of the crash as “a large fundamental trader”. That trader, against the general backdrop of unusually high volatility and thinning liquidity, initiated a programme to sell a total of 75,000 contracts, valued at approximately USD4.1bn, as a hedge to an existing equity position.

The trader chose to execute the programme via an automated algorithm, targeting an execution rate set to market trading volume, but without regard to price or time. As a result, the sell algorithm completed the sell program extremely rapidly in just 20 minutes. This, together with the reaction of other traders’ super-fast trading programmes to their consequent long positions, sent indices plummeting.

In a speech to the Wholesale Markets Brokers’ Association, Gensler said that a key lesson from the Flash Crash is that, “under stressed market conditions, the interaction between the automated execution of a large sell order and trading algorithms can quickly erode liquidity and result in disorderly markets, especially if algorithms use volume as a proxy for liquidity. The events of May 6 demonstrate that, in volatile markets, high trading volume is not necessarily a reliable indicator of market liquidity.”

He disclosed that the CFTC-SEC Joint Advisory Committee on Emerging Regulatory Issues has been asked to consider the report and make recommendations to both agencies. He listed some of the ideas that he looked forward to hearing about from that expert panel, as well as from market participants and the public.

In Gensler’s opinion, those ideas could include “requiring executing brokers to have an obligation to enter and exit in an orderly manner. Should executing brokers have to adopt certain trading practices when executing a large order by use of an algorithm, such as price or volume limits?”

As exchanges have maximum order size limitations and price banding that prevent entry into the trading engine of an order that exceeds a predefined maximum quantity or a price difference from the current market, he wondered whether executing brokers should have similar limitations, and whether they should have an obligation to monitor and make non-disruptive trading judgments.

He also looked for increasing visibility into complete order books, either in aggregate or in detail, and potential revisions to market pauses – either for single exchanges or for cross market circuit breakers.

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