Cause(s) of Stock Market Skid Still Elusive

Well, it now has been a few days since the New York Stock Exchange (NYSE) went into its historic free fall last Thursday.

An AP time lapse of the free fall is below:

So far, the investigations into the cause of the meltdown have failed to turn up a smoking gun.

Yesterday, the US Security and Exchange Commission (SEC) said in a press release that it had  "a constructive meeting with the leaders of six exchanges - the New York Stock Exchange, NASDAQ, BATS, Direct Edge, ISE and CBOE - and the Financial Industry Regulatory Authority to discuss the causes of Thursday's market events, the potential contributing factors, and possible market reforms."

Usually, the next paragraph in the press release would have been something along the lines of, "It has been preliminarily determined that the cause of the market events were ..."

However, in this case, there was no next paragraph. Not a good sign.

The next - and final - paragraph in the press release said, "As a first step, the parties agreed on a structural framework, to be refined over the next day, for strengthening circuit breakers and handling erroneous trades."  

While improved circuit breakers are obviously needed, not to be able to pinpoint a cause as of yet is more than a bit disconcerting to the average investor, as well as to many professional traders. In this Market Watch article today written by David Weidner, he quotes Irene Aldridge, portfolio manager at ABLE Alpha Trading Ltd. and author of a book titled, "High-Frequency Trading," as saying:

"What surprises me most is that they still haven't found out who did it. Regulators can reconstruct almost every single trade. They should be able to find out who did it. The real issue here is that the broker/dealers, by self-regulating, are not accountable to the government for the transactions their customers are doing."

Also disconcerting is that many of the investors who saw their trades reversed felt they got unfairly burned, while they perceived others were unfairly rewarded. As described in this Wall Street Journal article, trades in hundreds of securities got reversed, so thousands of trades and traders (no one knows how many yet) were affected.

An AP story says that today the exchanges that met with the SEC yesterday will update their circuit-breaker rules, create circuit-breakers for individual stocks, and establish clear rules for reversing trades.

The latest speculation about the cause of the free-fall is that it was a mistake. In the same article in Market Watch I cited above, David Weidner writes:

"The best guess here was that it was a mistake. This mess up was too big to be intentional. More likely: a trader pushed a wrong button. Things snowballed from there. The order was too big, triggering copycats -- many of these algorithms are built to piggyback trades. Someone -- probably a lot of people on Wall Street -- knows something about from where the trades came. In the end, someone's going to be embarrassed."

Interestingly, Mr. Weidner also writes,

"Until we know for sure though, maybe we ought to render these machines powerless to cause havoc -- by taking them out of the hands of people who by carelessness or malevolence put our system at risk."

More than a bit of hyperbole, I think, but really, can the genie of automatic trading ever be brought under control, or is the best that can be done now is to try to limit the damage when the genie goes rogue?

Update: 12 May 2010

Securities and Exchange Commission Chairman Mary Schapiro testified in front of the US House Financial Services Committee yesterday that regulators have not found a single cause of the market plunge last week. Chairman Schapiro said that there was no evidence yet of a "fat finger" mistake, that it was deliberate manipulation or a cyber attack.

You can read her testimony here.