Market orders, programmed trading and loss of thickness

I haven't yet read a convincing account of the one-day stock market crash and rebound on May 6, but here's an early (May 9, NY Times) story that makes a case that a lot of conventional market tools could have interacted to produce a bad outcome: Thursday’s Stock Free Fall May Prompt New Rules.

"The S.E.C., which oversees the nation’s equity markets, requires a suspension in trading only in the event of a broad market collapse, defined as a drop of at least 10 percent in the Dow Jones industrial average, which is based on the share prices of 30 large American companies.
Other countries, like Germany, impose similar circuit breakers on trading in shares of any individual company that has a similar drop, but the S.E.C. has never done so. A former S.E.C. official said the possibility had been discussed in recent years, but “I don’t think there was quite the urgency to deal with it.”
The S.E.C. and the Commodity Futures Trading Commission said in a joint statement on Friday that the issue now had their attention.
“We are scrutinizing the extent to which disparate trading conventions and rules across various markets may have contributed to the spike in volatility,” the statement said. “This is inconsistent with the effective functioning of our capital markets and we will make whatever structural or other changes are needed.”
Early this year, the S.E.C. also began a broad review of equity markets, including whether computerized trading is properly regulated.
The heads of several of the largest electronic exchanges said Friday that they would support industrywide rules for breaking free falls.
But there are other ideas to keeping computerized markets in check. Lawrence E. Harris, a finance professor at the University of Southern California, said regulators should simply require all sellers to specify a minimum price below which they do not want to complete the sale of their shares. Market orders, placed at the best available price, can be too risky in the fast-moving age of electronic trading.
On Thursday, some sellers placed orders that were not fulfilled until prices had plunged as low as a penny a share. If sellers had placed “limit orders” instead, those transactions would not have happened, Professor Harris said.
“Electronic exchanges in most other countries only accept limit orders,” said Professor Harris, a former S.E.C. chief economist. “Without any mechanisms to stop the market, we just had stocks falling through the ice.”
But Rafi Reguer, a spokesman for the electronic exchange Direct Edge, said retail investors liked market orders because limit orders could be rejected, forcing the seller to try again, in some cases at a lower price.
“Sometimes what people value is the certainty of execution,” Mr. Reguer said.
Experts also note that the value of limit orders can be subverted if investors routinely set unrealistically low limits, to avoid the inconvenience of having their orders rejected.
The BATS Exchange, a large electronic exchange based near Kansas City, rejects orders if the price would be more than 5 percent or 50 cents away from the last completed transaction.
During the market panic on Thursday, between 2:40 and 3 p.m., BATS prevented more than 47.6 million orders from executing — more than 95 percent of all orders during that period, according to Randy Williams, a spokesman for the company. "

And here's a May 19 NY Times story on the SEC's new rules: New Rules Would Limit Trades in Volatile Market
"The Securities and Exchange Commission said Tuesday that it would temporarily institute circuit breakers on all the stocks in the Standard & Poor’s 500-stock index after the huge market gyrations on May 6.
The circuit breakers will pause trading in those stocks for five minutes if the price moves by 10 percent or more in a five-minute period. The trial run will begin after a 10-day comment period and will last through Dec. 10, the commission said. The circuit breakers will apply both to rising and falling stock prices.
But in a separate report, the S.E.C. and the Commodity Futures Trading Commission said that they had not been able to pinpoint the cause of the sharp market decline that shook investors and markets two weeks ago.
Generally, the agencies said, the drop was caused by traders stepping back from the market and refusing to buy or sell, in both the stock and futures markets. The government found that there was also a heavy reliance by investors on automated orders to sell at the market price once stock prices had declined by a certain amount. Further, there were different rules on different exchanges about when trading is automatically slowed or stopped. "