I can’t drive 55," sang Sammy Hagar, kicking off the battle to repeal the hated 55 miles per hour national speed limit. As the issue gained steam with the public, safety advocates argued that raising speed limits would lead to thousands of additional deaths. Ralph Nader led the opposition, going so far as to angrily state, "History will never forgive Congress for this assault on the sanctity of human life."
But after the repeal sailed through Congress in 1995, history proved to be more forgiving than Mr. Nader expected. As speed limits were raised, the rate of highway fatalities actually dropped over the ensuing years, a trend which continued to the current record-low level of one death per 80 million miles driven, down 28 percent from 1995. Attributed to engineering improvements like airbags and anti-lock brakes, the decrease demonstrates that we can go fast and still be safe, with the right safety mechanisms in place.
Fifteen years later, Mr. Nader is again championing speed limits, this time in our nation’s stock markets. His preferred trading speed limit comes in the form of a 50-basis-point transaction tax, and he has turned up the volume on his advocacy since the May 6 "flash crash."
At an event in Buffalo, N.Y., in early August, he declared that without the transaction tax, "we better start describing the USA as a corporate plantation with 300 million serfs." Others are also opportunistically using the flash crash as a justification for slowing down the markets, with pundits proposing everything from one-second waiting periods for trades, to standardized delays in data feeds.
Safe and Fast
Serfdom aside, slowing trading is a nonsensical solution if the stated purpose is to prevent a recurrence of the events of May 6. As with the highways, we can drive fast and be safe with a few well-designed safety mechanisms. The regulators have taken steps in the right direction with the new single-stock circuit breakers that have been implemented for a six-month pilot period.
The breakers trigger when an S&P 500 stock moves 10 percent within a five-minute window, and initiate a five-minute trading halt. Rather than an inefficient speed limit that slows down everyone, the circuit breaker is more like an airbag, a dramatic safety mechanism that explodes open only in the event of an accident.
The market airbags have proven workable, although they are far from perfect in their current form. In the first six weeks of the new rule, the circuit breakers have triggered in five stocks, with four of the incidents being caused by small errors. The first one was in Washington Post on June 16, triggered when a few hundred shares printed on the Arca exchange more than 100 percent above the previous trade. The bad trades were later removed from the tape as "clearly erroneous," and no one seemed to mind very much. But when the next circuit breaker was tripped, traders started to grumble.
On June 29, Citigroup’s stock halted, caused by a bad print that hit FINRA’s Trade Reporting Facility at a price 17 percent below the previous trade. Whereas Washington Post averages 60,000 shares per day, Citigroup is one of the heaviest-traded securities on the planet, averaging 640 million shares per day this year.
Did it really make sense for the entire world to stop trading the stock due to one bad print of a few shares? Even worse, the Citi print hadn’t even disrupted the bid/ask spread-it was as if the police had shut down I-95 in both directions because someone forgot to signal when changing lanes.
On July 23, we finally hit the fun scenario-genuine news. As reports were posted that Genzyme was in takeover talks with Sanofi-Aventis, the stock rallied 10 percent in 4 seconds, hitting a five-minute pause before reopening on a large print. Some traders were upset by this one, too, although they are unlikely to get much sympathy on Main Street with their chief complaint: that the halt didn’t allow traders to profit while there was still some "juice" left in the news. In a real-world news scenario, the breakers demonstrated that they do create an orderly environment, and whether you think it’s for better or worse, they do level the playing field for all investors.
Fender Benders
Regardless of why they were triggered, the circuit breakers had an interesting side effect. On the highway, everyone always stops to look at the wreckage after an accident. Similarly, Wall Street focused on these relatively minor stock market fender-benders, which were covered on CNBC and picked up by dozens of Web sites and the mainstream press. The attention paid to these errors is a bit problematic-four of the five were routine little problems, and yet the circuit breakers gave the public the impression that all hell was breaking loose in the affected stocks. The lure of crashes may be why people watch Nascar, but it shouldn’t be the reason to watch Nasdaq.
Instead of halting a stock due to a single bad print, why not prevent the bad trade from happening at all? Several clever engineering solutions are being floated around the Street that would accomplish this, such as price collars that would define "clearly erroneous" trades in real time, and then prevent bad prints from hitting the tape. Then, anything that is allowed to print would by definition not be erroneous, and traders could be confident that if they get a fill, it would never be reversed later in the day. Regulators should take this opportunity to clean up the "clearly erroneous" mess once and for all.
Of course, there would be no errors in the first place if no one ever sent orders at crazy prices. In any serious evaluation of our market structure, we need to acknowledge that market orders are inherently dangerous, and that they are the origin of most price disruptions. A market sell order can trade down to zero, while a market buy order can take a stock to the moon. They are the highway equivalent of a sticky accelerator pedal-once pressed, the car goes at maximum speed with no way to slow down. This is an easily solved problem: Eliminate them. The BATS exchange converts market orders into limit orders that are at most 5 percent away from the current price. If all brokers and exchanges implemented similar rules, errors would mostly become a thing of the past, with or without circuit breakers.
When regulating either highways or markets, the goal should be the same: Look for targeted solutions to correct problems, without unnecessarily slowing everyone down on normal days. The first six weeks of the new circuit breakers have proven that targeted engineering solutions are implementable, even in today’s complex markets.
And that means that we can design complex safety tools that will allow us to be safe at high speeds. Give this some thought if you hit the road this coming summer weekend. As you’re cruising down the highway with the radio blasting, safer than ever thanks to your airbag and seat belts and crumple zones, push the pedal down, hear the engine rev up, and thank Sammy Hagar that you don’t have to drive 55.
Dan Mathisson, Managing Director and Head of Advanced Execution Services (AES) at Credit Suisse, is a columnist for Traders Magazine. The opinions expressed in this column are his own, and do not necessarily represent the opinions of the Credit Suisse Group.
The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine or its staff. Traders Magazine welcomes reader feedback on this column and on all issues relevant to the institutional trading community. Please send your comments to Traderseditorial@sourcemedia.com
