The Flash Crash – And Near Misses – Four Years Later

Yesterday marked the fourth anniversary of the May 6, 2010 Flash Crash – that infamous moment at 2:45 pm in the middle of an unforgettable day in 2010 when a stomach-turning roller coaster like drop and recovery in securities prices occurred. And while everyone vowed that history would not repeat itself, a lot has happened in the regulatory landscape since that time that’s indicated close calls, resulted in a lot of dialogue and in the implementation of (hopefully) preventative reforms.

Walter Ferstand, NICE Actimize

In the wake of this event, one of the most publicized regulatory reforms that emerged from this crisis was the adoption of Rule 15c3-5 (Market Access Rule) toward the end of that year, in November of 2010. The practice and evolution of brokers granting unsupervised direct market access to global markets to accommodate their clients; actually contributed to the foundation of ultra-high-speed trading technologies and increasingly complex algorithms caused a spiraling down effect in the regulatory world.

The Flash Crash, however, put a spotlight on the dangers of such an arrangement and the Securities and Exchange Commission took measures to quell that. The rule requires all broker-dealers with the ability to trade directly on an exchange and alternative trading system (ATS) to have a broad range of risk management controls in place. The intention of the rule has been to limit broker-dealers' potential financial exposure in connection with direct trading on the markets.

Rule 15c3-5 also required that broker-dealers with market access to establish, document, and maintain a system for regularly reviewing the effectiveness of supervisory procedures and for promptly addressing any issues; and no less frequently than annually, conduct a review of its business activity in connection with market access to assure the overall effectiveness of such risk management controls and supervisory procedures and document that review.

As part of a more sound risk management approach, the Rule also stipulated that the Chief Executive Officer of the broker dealer to annually certify that the risk management controls and supervisory procedures comply with Rule, and document that regular review has been conducted. The Rule’s CEO certification requirement is a separate and distinct certification from the FINRA Rule 3130 certification requirement; however a FINRA member firm could leverage its current process for compliance with FINRA Rule 3130 to perform the required certification under the Rule.

So, how has this all been working out over the past four years? Overall, the rule has been a success and currently broker-dealers are now, in real-time, monitoring the risks associated with market access, so as not to jeopardize their own financial condition, that of other market participants, the integrity of trading on the securities markets, and the stability of the financial system.

At this point, FINRA and the other main exchange SROs (Self-Regulatory Organizations) are actively policing their participants/broker-dealers to ensure they have sufficient procedures, adequate surveillance tools, or necessary information to monitor DMA (Direct Market Access) and SA (Sponsored Access) client trading. The industry is receiving annual regulatory sweeps and periodic inquires as to the firms procedures, if they are not adequate, then sanctions (fines) have been handed out.

So, as the anniversary of the Flash Crash approaches, all SA and DMA providers need to continue to review their processes and controls in this area. It's quite possible that they'll find many ways to improve their written supervisory procedures (WSP’S) and, by default, make sure the regulators are satiated and they are subsequently able to avoid fines.

However, it is important to note that, while there have been significant progress in this area of compliance since the Flash Crash and the markets largely have avoided any other similar catastrophic events, there have been several well-documented instances in the last four years of near misses across all US markets testing the risk management controls put in place by the SEC. These near misses were, in fact, “near misses” because at both the exchange and broker dealer levels, sound risk management processes were in place to catch erroneous program trading.

Industry professionals as a whole and regulators alike, continue to address market structure and its complexities. As the U.S. markets now sit at all-time highs, largely fueled by improving economic conditions, now is the time to re-address (update) the rules put in place and determine if they fell short of the original plan’s objectives. As volumes remain relatively low, investors need to gain trust and regulators need to reestablish confidence – and perhaps take a look at high speed trading and other aspect of the market that were not addressed in the initial rollout of the rules.

In all seriousness, regulators need to continue to think of the Flash Crash as a possible precursor to a meltdown of the global financial system. It’s very clear that machines are driving the markets and between 60-70 percent of all trading is done by automated high frequency trading computers. While machines don't control the broad direction of the markets, a great deal of the day-to-day fluctuation can be ascribed to algorithms, ultra-fast computers, and a set of systems that have been built up to remove human agency from stock trading.

So as we re-evaluate four years later, the regulators and the rest of the industry needs to continue to ensure the trading systems; market structure and current rules address unusual activity in the market and are designed to accommodate huge spikes to avoid a repeat performance. We prefer our roller coaster to be sitting at the gate, not at the top of the hill ready to plummet.

—Walter Ferstand, NICE Actimize, Subject Matter Expert, Capital Markets Compliance.