‘Flash Crash’ postmortem: How some buyers got stocks for a penny, without even trying
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How was it that some big-name stocks temporarily sold for a mere 1 cent a share in last Thursday’s market dive?
Securities and Exchange Commission Chairwoman Mary Schapiro, testifying before Congress on Tuesday, took a stab at explaining some of the technical reasons for the trades that occurred at near-zero prices -- while stressing that the agency still didn’t know what triggered the brief collapse in the first place.
We already know that investors and traders who used “market” sell orders during the late-afternoon plunge were most at risk, because those orders are supposed to be executed at the prevailing best market price (as opposed to “limit” orders that have specific price instructions).
As sell orders poured in late Thursday, while buy orders dried up, the sell orders within the market trading network kept trying to find a buyer -- anywhere and at any price.
But who was smart enough to be offering to buy shares for mere pennies at that point?
Here’s Schapiro, in her testimony:
Finally, the absurd result of valuable stocks being executed for a penny likely was attributable to the use of a practice called “stub quoting.” When a market order is submitted for a stock, if available liquidity has already been taken out, the market order will seek the next available liquidity, regardless of price. When a market maker’s liquidity has been exhausted, or if it is unwilling to provide liquidity, it may at that time submit what is called a stub quote -- for example, an offer to buy a given stock at a penny. A stub quote is essentially a place holder quote because that quote would never -- it is thought -- be reached. When a market order is seeking liquidity and the only liquidity available is a penny-priced stub quote, the market order, by its terms, will execute against the stub quote. In this respect, automated trading systems will follow their coded logic regardless of outcome, while human involvement likely would have prevented these orders from executing at absurd prices. . . . We are reviewing the practice of displaying stub quotes that are never intended to be executed.
As we know, some of those deep-discount trades were canceled after trading ended Thursday because they were “clearly erroneous.” But the threshold set by the New York Stock Exchange and Nasdaq for cancellation of a trade was a price 60% or more removed from the price shortly before the dive occurred.
That still left some unknown number of investors stuck with the consequences of market sell orders that were executed within the 60% limit.
Why did the exchanges set the cancellation threshold at 60%? Because they could: The SEC gives them discretion under such circumstances.
Eric Noll, executive vice president of Nasdaq parent firm Nasdaq OMX Group Inc., told Congress on Tuesday that there was “significant debate among the exchanges regarding the proper break point” at which to cancel a trade, before officials agreed on the 60% price-decline threshold.
Reuters reports that Nasdaq officials actually wanted a higher threshold -- 80% -- while other markets wanted to cover more burned investors by setting the cancellation price threshold at 50%. The 60% figure was the compromise.
Of course, any quick-fingered investors who were entering real buy orders (as opposed to stub quotes) at deeply discounted prices during the short-lived crash also were burned if their trades were revoked. Schapiro nodded to those buyers’ frustration, saying that they ‘were not rewarded for their willingness to buy when everyone else was selling.’
-- Tom Petruno