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SKARBECK: Exchanges' proposed fix for glitch is ludicrous

May 15, 2010

Ken Skarbeck InvestingLawmakers and regulators, already with their hands full trying to craft intelligent financial reform, were thrown another big curveball May 6 when stock market trading briefly ceased to function normally.

On that Thursday afternoon around 2:40 p.m., the Dow Jones industrial average was already down about 300 points on the European debt crisis. In the next five minutes, the market lost 700 points in a free fall that saw numerous stock trades completed at bizarre prices (one $40 stock traded at $0.00001). What is particularly alarming about this episode is that nobody knows exactly what happened.

The New York and Nasdaq exchanges decided to resolve these oddball trades by busting transactions in any stock with a price deviation of greater than or less than 60 percent from its published reference price. The arbitrary choice of a 60-percent price swing is quite frankly absurd. As you might imagine, it created a lucky group of winners and a vocally upset batch of losers.

I admit I do not pretend to have an understanding of the logistical effort required to sort through millions of transactions to identify rogue prices. However, it would seem a much smaller range than 60 percent would be more rational—perhaps 10 percent?

Conservative consumer products giant Procter & Gamble is an example of a stock where trades will clear at irrational prices within the 60-percent swing range. P&G’s stock was trading around $62 per share that day. During the free fall, a rogue trade in Procter and Gamble’s stock was executed at $39.37, more than 35 percent lower than its value a few minutes earlier. It’s been nearly 10 years since P&G traded below $40 a share; however, under the exchanges’ arbitrary rule, that transaction is valid. Now you will have a hard time convincing any long-term investor that P&G’s intrinsic business value dropped 35 percent at any point in time on May 6. Investors who innocently chose to exit their position that day and got stuck with a 35-percent haircut should be hopping mad.

All of which raises some disturbing questions: Have regulators lost some control of the markets, hijacked by high-speed computers and hedge funds churning out mathematical algorithms that now dominate 70 percent of daily market trading? The published list of some 450 stocks where trades on May 6 will be completed at nonsensical prices says maybe so.

Is investing becoming a technology-rigged game for computerized gamblers who rent stocks for seconds or minutes and whose objective is to repeatedly skim small profits? Are traditional investors—who believe the stock market exists to provide patient long-term capital for American businesses to facilitate their growth—becoming dinosaurs?

Regulators had better get their hands around the high-frequency traders and dark pools who play by different rules. These high-speed computer traders regularly tout the liquidity they provide as a benefit to all investors, yet it has been reported that several of these outfits turned off their computers during the May 6 plunge.

The initial solution appears to be a new set of “circuit breakers” that halt trading when the Dow Jones average or individual stocks fall more than a soon-to-be-established percentage. More will need to be done as this problem cannot be allowed to recur. Unexplained market free falls and poorly-thought-out trade resolutions will do lasting damage to market integrity.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.

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