NASDAQ’s '60% Rule' - Part 2

Includes: NDAQ, NYX
by: John D. Frankola

Several days ago I published an article on Seeking Alpha (NASDAQ's '60%' Rule: Arbitrary and Suspicious) which discussed the decision of US Exchanges to cancel certain trades which occurred last Thursday afternoon during the “Flash Crash”.

I was subsequently contacted by a representative of NASDAQ OMX Group (NDAQ). I was asked by the representative to amend my Seeking Alpha article to state that all US markets participated in determining the “60% ruling” regarding the cancellation of trades last Thursday. In addition, the NASDAQ representative noted that a Security and Exchange Commission employee monitored the call in which the decision was made.

In my article I quoted the NASDAQ’s press release stating that “NASDAQ has coordinated a process among US Exchanges…” In subsequent references to the decision makers regarding this matter, I simply referred to NASDAQ. From the press release, I had made the conclusion that NASDAQ had the lead role in the process.

In any case, the NASDAQ representative wanted me to clarify that all US markets as well as the SEC participated in the process. I told her that I had tried to diligently research this matter and had not seen a reference to the SEC. She informed me that on May 9, 2010, subsequent to the publication of my article, the NASDAQ issued the following statement:

The NASDAQ OMX Group (Nasdaq: NDAQ) and NYSE Euronext (NYSE: NYX) are committed to working closely with each other, the Securities and Exchange Commission, other regulators and all market participants to determine the cause of Thursday's market plunge and to develop effective solutions promoting greater market stability, efficiency and transparency.

We commend the Securities and Exchange Commission for their continued leadership during this critical time in global markets and agree that a constructive process will promote confidence in the financial markets by investors, listed companies and market participants.

In her comments to me, the NASDAQ representative made it very clear that the SEC monitored the process which resulted in the “60% ruling”, although the press release above only commends the SEC for their continued leadership.

While I appreciate NASDAQ’s effort in contacting me to help clarify this matter, the major point of my article remains, how was the 60% ruling determined?

These trades were executed based on legitimate instructions submitted to exchanges. As has been reported, there were no errors attributed to trading systems. There were winners and losers in this matter. Unfortunately, it was the exchanges and regulators who determined the outcome. The person whose sell order was executed at 60% below the last “good” print was a loser, since the trade was considered valid and prices quickly recovered. The person whose sell order was executed at 61% below the last “good” print was a winner, since her trade was cancelled, and the loss was avoided. How does this make sense? You had other winners and losers on the opposite side of each of those transactions.

(I was one of the individuals that suffered an opportunity loss, as I had purchased an ETF approximately 70% below the last “good” print. The purchase was subsequently cancelled.)

In my opinion, investors need more transparency to buy-off on this decision. How was the 60% determined to be the fair amount of loss? What was the total amount of loss avoided by sellers (opportunity loss of buyers) by trades that were cancelled? (Were billions of dollars of transactions voided?) Who were the winners and losers – institutions or individuals? What happens the next time there is a similar drop?

It is my belief that either all trades should have been broken, all trades should have been allowed, or as I mentioned in my article, if 60% was determined to be a fair price considering the market mayhem, then transactions occurring at less then 60% should be executed at the 60% level.

The House testimony of Eric Noll, Executive Vice President of the NASDAQ OMX Group, Inc. concerning this matter is available here.

Disclosure: No positions in stocks mentioned.