May 7, 2010 / 9:36 PM / 10 years ago

Plunge highlights fragmented markets, fast traders

NEW YORK (Reuters) - The sharp fragmentation of markets and their reliance on independent trading firms took centerstage on Friday, with exchanges sniping at each other a day after a steep and mysterious market drop rattled investors worldwide.

The cause of Thursday afternoon’s unprecedented plunge in the Dow Jones industrial average — the DJIA lost 600 points in five minutes before markets eventually recovered most of those losses — was still unclear.

But traders and exchanges said the reason it all unfolded so quickly was a lack of market-wide circuit-breaker standards that would halt trading, along with rule changes in the last decade that made the U.S. stock marketplace the fastest on earth.

William O’Brien, CEO of Direct Edge, which handles some 10 percent of all trading volumes, said: “The systems should have been closed down for a period of time, market-wide.”

“It doesn’t help that different markets operated differently,” said Joe Ratterman, chief executive of BATS Global Markets, the third-largest exchange group.

A breakdown in the world of electronic exchanges is seen as one reason at least a half-dozen stocks, including Accenture and Exelon Corp, briefly traded for as low as a penny a share during the worst of the meltdown.

The New York Stock Exchange introduced a trading curb on its floor Thursday that forced most trading to all-electronic exchanges such as the Nasdaq Stock Market and NYSE Euronext’s Arca venue.

Nasdaq OMX Group Inc CEO Robert Greifeld sparked a televised spat with its main rival, telling CNBC that NYSE’s use of the so-called Liquidity Refreshment Point was akin to walking away from its listed stocks.

While NYSE shot back that the move was prudent, others said it accelerated selling and exposed the need for a market-wide stock-specific circuit breaker to stop such meltdowns.

“The fact that the exchanges’ responses were different seemed to exacerbate the problem,” said a high-frequency trader who requested anonymity due to the sensitivity of the regulatory probe. “Some kind of harmonization I think will be an important part of whatever solutions are proposed.”

Regulators discussed the meltdown with exchange officials well into the night and probed the market drop Friday.

A handful of high-frequency trading firms told Reuters they stopped trading, citing the heavy market plunge and uncertainty over which trades would be canceled.

RELYING ON HIGH-FREQUENCY TRADING

Trading speeds and volumes have ramped up the last few years as regulators encouraged the proliferation of new trading venues to challenge the incumbents’ near monopoly. In the last year, the U.S. Securities and Exchange Commission raised some red flags about the fragmented marketplace and so-called high-frequency trading, with few big changes.

“There was a flaw when this type of volume builds up and one exchange has a circuit breaker and the others don’t operate in the same manner ... clearly there isn’t a coordinated standard,” said Larry Leuzzi, a trading advisor to Gap Partners and a former executive at ICAP.

Exchanges and investors have come to rely on the liquidity of high-frequency traders (HFT), which use lightning-fast algorithms to make markets and capitalize on tiny imbalances. They have come under the microscope in recent months in the SEC’s wide-ranging review of markets.

“In my view HFT is parasitic and it needs to be reined in,” said Jack Ablin, chief investment officer at Harris Private Bank in Chicago, where he oversees $55 billion. “It’s noise,” he added.

It’s not uncommon for market makers to have standing bids and offers for stocks at various prices — often at prices well below what anyone reasonably expects a stock to trade down to. Think of these as sort of worst-case bids and offers.

But during that vicious 10-minute market plunge, some stocks plunged to those bottom of the barrel prices in part because some electronic market makers had stopped trading.

“The market would feel better if there was some glaring mistake made somewhere along the line because it would make what happened more comprehensible,” said Rick Meckler, president, LibertyView Capital Management, in New York.

“If that’s not the case and it’s just the result of today’s machine-driven trading it will be more worrisome and cause to pull back further from the market.”

Reporting by Jonathan Spicer, additional reporting by Matthew Goldstein, Emily Flitter, Clare Baldwin and Rodrigo Campos; Editing by Gary Hill

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