As Market Volatility Continues, the Blame Game Heats Up

Regulation, the loss of specialists, electronic trading -- they're all on the list when it comes to placing blame for recent market volatility.

Volatility is the norm these days as the markets experience dramatic ups and downs amid the global financial crisis. The government announces a bailout plan -- the market tanks. The government announces tweaks to the bailout plan -- the market jumps.

In fact five of the 10 biggest point declines on record for the Dow Jones Industrial Average occurred in September and October of this year. Five-, six-, even seven-hundred-point drops have become commonplace, and traders have been on a roller-coaster ride of gains and losses. It's a brave new trading world, and volatile markets reign.

Many have been quick to point the finger at widespread electronic trading -- in particular, program trading -- as a major culprit behind stocks' wild ride. (Program trading as defined by the New York Stock Exchange is "a wide range of portfolio trading strategies involving the purchase or sale of 15 or more stocks having a total market value of $1 million or more.")

Others have suggested that the industry was too quick to dismiss the specialist model on which the exchanges historically relied. The New York Stock Exchange, for example, has just six specialist firms on the floor today, down from more than 40 in the early 1990s.

The specialist concept was originally put in place to increase liquidity and ultimately provide more-efficient trading. The specialist's role is to act as a dealer and provide liquidity and depth when the markets are unbalanced. Specialists assigned to a certain security are obligated when demand goes up to sell their firm's inventory or short the stock, often at prices higher than the current bid/ask spread. But as electronic trading has taken over and the NYSE has moved to a hybrid model, specialists don't have the same incentives; as a result, the markets are very different today as there is no liquidity guarantee in volatile times.

In addition to the influx of electronic trading, since the heyday of the '90s the markets have seen many other changes, including the move to decimals, which narrowed spreads and decreased average trade sizes; the repeal of the Glass-Steagall Act, which separated commercial and investment banking; and the removal of the uptick rule. The uptick rule required that short sales occur only at a price that is higher than the price of the previous trade to prevent short sellers from contributing to the downward spiral of a security in volatile times.

Most experts agree that the root of current volatility doesn't trace back to one cause but rather is a culmination of events that have left the markets more fragmented and less regulated than ever before.

Could Specialists Have Prevented the Crisis?

Could specialists have made a difference? Ultimately, we will never know.

Linda Sarkisian, director of trading at Ft. Lauderdale, Fla.-based Olympian Capital Management and a former specialist on the Boston Stock Exchange for 25 years, believes specialists could have made a difference at the height of volatility, but she says the way the markets operate today is so different that additional measures still would have been necessary to calm the markets. "There is no one responsible for the market [today] -- the specialists would help," she asserts. "But in order for them to be able to do their jobs, there is going to have to be other regulation to go with it and a more centralized marketplace."

According to Olympian's founder and chief investment officer, Michael Levas, "Specialists add a lot of credence to the market -- a certain amount of consistency and a reliability that we need in the marketplace."

But Levas adds that the market also needs more structure today. "We used to even have leverage limits -- max was 15 to 1 leverage; now it's 40, 50 to 1, whatever. We need those guidelines and that foundation," he says. "Any organization -- government, corporations, businesses -- all have structure, and we need structure here."