What Can Be Done to Prevent Another Stock Market Dive?

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For the past year, market watchers have had a growing unease about something called high-frequency trading. The fear was that largely unchecked supercomputers trading in nanoseconds and set on autopilot could cause the market to plummet for no real reason at all. On May 6, those fears were realized when the market plunged hundreds of points in less than 20 minutes.

It's still not clear exactly who or what started the drop. But what is clear is that even if a computer glitch or a trader's goof got the ball rolling, the structure of the market turned one bad trade into a market collapse. At the heart of the problem is a decade-long push to lower the cost of buying and selling stocks. That was supposed to lure individual investors not wanting to pay hundreds of dollars a trade into the market. But the result seems to be a herky-jerky market for stocks that individuals can now afford to be a part of but increasingly don't want to. Even before last week, the Securities and Exchange Commission was soliciting comment letters from market participants about what should be done to fix glitches that could occur in the increasingly computerized and fragmented market. There are a number of ideas floating around Wall Street. Not everyone agrees on what should be done. But what almost everyone believes is that we need to do something to fix the market.

"Our current stock market model is broken," says Joseph Saluzzi, co-founder of Themis Trading, who has sounded the early-warning signal on high-frequency trading. "If we don't do anything, this will happen again."

Here are some of the most common proposals:

Halt Stocks, Not Markets
During the height of the market panic on May 6, the New York Stock Exchange (NYSE) stopped trading. That wasn't a mistake or glitch; it was on purpose. It's called a circuit breaker, and it is supposed to calm the market. Traders and regulators can step in and see if a mistake has been made. Most important, it is supposed to help buyers get into the market who might otherwise not want to buy in as everyone is scrambling for the exits. But on that day the NYSE's brief pause did the opposite: it made the situation worse. That's because the NYSE only accounts for about 40% of the trading volume of stocks these days, down from nearly 100% a decade and a half ago. The rest of the buying and selling occurs elsewhere on various electronic exchanges, including the Nasdaq and many others. So when the NYSE shut down, it didn't cause stocks to stop trading as it would have done in the 1980s or even the early 1990s. All it did was make the market function more erratically. With 40% of the volume of the market closed down, it became harder and harder to find willing buyers. Stocks that were already headed lower began to nose-dive.

The solution is not to have market-based trading halts, but stock-based trading halts. So if Procter & Gamble were to fall $20 in mere minutes, as it did on May 6, regulators would stop the trading of that stock everywhere, not just on the NYSE.

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Keeping Up (Barely) with the Market's Wild Volatility

Last year, when finance professor Robert Schwartz decided to put together a conference on volatility in the markets, nobody knew just how timely it would be. In the past few weeks, triple-digit swings in the Dow Industrials have become a matter of course, as seasick investors watch stocks bound up and down, pounded by the day's news, and often, it seems, for no discernable reason at all. In the first few minutes of trading on Friday, stock indexes dropped 5% as the double whammy of deleveraging and a worldwide economic slowdown continued to buffet company shares.

If you think you've been on a roller coaster ride watching your brokerage account, spend some time with the professional traders, platform operators, and stock exchange executives who deal with stock prices on a minute-by-minute basis. At Thursday's volatility conference, held at City University of New York's Baruch College, some of the people closest to the market swapped stories of operating in such a harried environment. "Everything happens so quickly now, you don't have time to digest it," said Tim Mahoney, CEO of Bids Trading, an order execution firm, speaking from the dais. "I'm grateful to be here and not on the desk," joked George Bodine, the director of trading at General Motors Investment Management. "It gives me one day of reprieve."

Overwhelmed by investors responding to every little tick of the market, companies that clear trades are easily seeing ten times the usual number of messages that signal the price at which investors want to buy or sell. Traders with algorithm-based strategies are jockeying for space at the computer servers closest to stock exchanges in order to shave milliseconds off their trades. This is what the market has come to: the distance an electron travels makes a difference.

The academics in the room tried to provide some historical perspective. Robert Engle, a finance professor at New York University, put up a chart showing how volatility has played out over the past 80 years. Two bulges were large enough to rival the amount of volatility we're seeing today, representing the stock market crashes of 1929 and 1987. The difference between the two: while the market quickly calmed down after 1987, it took years to regain a sense of normalcy after 1929. "We don't know if this is a '29 or '87 type of spike," Engle said. "We're all trying to figure that out."

In the meantime, traders are dealing with price swings the best they can. Blocks of shares bought and sold have grown smaller, as traders shy from committing too much of a position at one time, lest they pass up a better price later. As margin calls and redemptions from mutual and hedge funds drive trading particularly wild in the opening and closing minutes of most sessions, algorithm-based traders are rewriting programs to squeeze their moves into increasingly narrow bands of time. "It may be good, it may be bad, but I don't thank any of us can stop it," said Robert Almgren, co-founder of Quantitative Brokers.

Though stock exchanges are trying to, at least at the margin. Reto Francioni, CEO of Deutsche Borse, a stock exchange in Frankfurt, described how volatility disruptions now kick in hundreds of times a day. When a stock's price jumps outside of its proscribed range, word goes out and trading switches over to an auction format for about five minutes to give all the market participants a chance to regroup, process any new information they might have — and to prevent the volatility from feeding on itself. "When markets aren't acting rationally, it's healthy to slow them down," said Richard Rosenblatt, CEO of the trading shop Rosenblatt Securities.

And yet ultimately volatility might simply be part of working through the effects of the credit crunch. The world is undergoing a great deleveraging and all that unwinding has ramifications. At the same time, the onslaught of market moving news — economic data, corporate earnings, governmental action — keeps coming. There is a massive uncertainty in the air, and in a market it is perfectly logical — perhaps even necessary — for uncertainty to be reflected in asset prices. Uncertainty, as reflected in volatility, is legitimate information, too. In a panel discussion about volatility's implications, Morgan Stanley executive director Robert Shapiro took a step back and asked: "Why is volatility inherently bad?" Maybe it's not. But it is kind of ugly.