Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Did the NYSE Circuit Breaker cause the Flash Crash?

|Includes:SPDR S&P 500 Trust ETF (SPY)
A number of high frequency traders sold their positions and exited the market in the minutes before the May 6 “flash crash”.
The question regulators need to answer before they add new circuit breakers is: “Why did traders exit the market?”
When you look at the daily chart after 2 p.m. it’s pretty obvious that the market was going down rapidly and in a few minutes a 10% down circuit breaker could be trigger on the New York Stock Exchange. The circuit breaker would have shut down trading on the NYSE for 30 minutes. If you are a trader with an average stock ownership time of 11 seconds you want to avoid a 30 minute forced hold like the plague.   You also want to have a lot of liquidity for when the market opens again. Exercising the better part of valor, you might sell everything and wait for the dust to settle.
If enough traders do this, the “flash crash” could have occurred because of a lack of buy orders. These traders had very short holding periods (11 seconds, some less) so there might not have been an unusually large surge in sell orders but there would have been a lack of offsetting buy orders. Add sloppy programming and you get stocks with no bids priced at zero: Flash Crash!
In slow motion:

    Market goes down and approaches Circuit Breaker level
          Some High Frequency Traders into exiting market.
                                   Resulting in
                                   Lack of bids
                             which combines with 
                              Poor programming
                                    to give a
                     Flash Crash with bids of zero!

The thing that is happening right now is everybody is fixing the poor programming so there will be an orderly market (no bids of zero) if this happens again.
This means that the next time the market starts toward a circuit breaker due to a high volatility day there will be no Flash Crash to disrupt the market and it will get to the circuit breaker.
Imagine what will happen if all major markets in the USA are shut down at once:
  • Traders who still have open positions will try to adjust them on whatever secondary markets are open. 
  • The extra volume overwhelms these markets in seconds forcing trading to suspend on them
  • Instant global crisis
Circuit breakers will increase market volatility if High Frequency Traders need to be out of their positions before a circuit breaker kicks in. As markets approach circuit breaker levels buy orders will disappear and the market decline will accelerate toward the circuit breaker.
Setting Circuit Breakers at 5% will just make it more likely that they will be hit and if they are uniform across all US markets then it will cause an international crisis.
Shutting down the market with a circuit breaker does not even have any theoretical justification because it eliminates price discovery. The reason High Frequency Traders must be out of the market is because they cannot do price discovery or even minor adjustment to positions.
The proposed trading stops in individual stocks are only going to encourage traders to exit quicker. The scary issue is that these stops may seem to work during a test period if there is no major event but during a general collapse they will quickly drive out computerized traders as information flow become erratic due to stocks going in and out of trading stops. As traders decide that the market is untradeable and leave the general decline will accelerate.
Rather than circuit breakers, regulators should look at slowing computerized trading during times of extreme volatility. Collars using a simple buy minus or sell plus rule worked very well at limiting volatility and a 2010 version should be considered in the place to the original 1987 collars. The excuse that uptick rules can’t be done with modern computerized trading misses the point.
Regulators need to remember that the objective is to allow orderly price discovery without a market collapse and this probably means that the ability of traders to make money with their fancy computers may disappear for a few hours.
Perhaps I’m wrong that high frequency traders want to be out of the market during a general market shut down or will have no problem when a large number of stocks are timed out – but I don’t think investors who are less risk tolerant than I (most investors) want to take the risk.

Disclosure: Author holds short positions in the S&P 500 and the NASDAQ 100
Stocks: SPY