If securities regulators had any doubt that the trading business has evolved far beyond the rules designed to keep markets fair and orderly, the short-lived crash that occurred in the U.S. in early May should dispel any lingering uncertainty. The big question is: what, if anything, to do about it.

Well before the so-called “flash crash” that took place on May 6 — when the U.S. markets suffered a sudden, precipitous decline and then quickly rebounded — regulators in both Canada and the U.S. were looking at recent innovations in trading, pondering how to set the rules of the road in this fast-changing world.

Those deliberations took on a new sense of urgency when the market disruption took place. After trading downward for much of the day, the Dow Jones industrial average began tumbling sharply at about 2:40 p.m., losing almost 1,000 points before recovering a significant chunk of that loss in the next 20 minutes. The trading activity that occurred that afternoon generated some extreme results in both individual stocks and exchange-traded funds, and a slew of those trades were later cancelled or repriced at the end of the day, including some trades in Canada.

Seemingly, something had gone wrong, although it wasn’t clear what. So, regulators in the U.S., Europe and Canada all promised to investigate the plunge. Everything from trading mistakes to systems failures and even sabotage were proposed as possible causes.

A preliminary investigation by the U.S. Securities and Exchange Commission and the U.S. Commodity Futures Trading Commission found no evidence that the plunge was triggered by trading errors, computer hacking or terrorist activity, although officials conceded that they could not completely rule out these possibilities.

Assuming that these sorts of peculiar events aren’t to blame, the logical conclusion is that the crash was merely one of the possible results of normal trading activity under the current market structure. This structure is made up of multiple competing markets and increased electronic trading, which has brought a relentless push for faster systems and more complex algorithms, along with increased market fragmentation.

The preliminary report by the SEC and the CFTC says the regulators are looking at a number of possible factors that could have contributed to the crash, including: a sudden withdrawal of liquidity by electronic traders; the use of market orders, including automated stop-loss orders, and whether that contributed to the trading volatility; whether the loss of liquidity was exacerbated by the existence of different trading conventions in different trading venues; the interaction between stock index products and stocks themselves; and the impact on exchange-traded funds.

While these initial investigations haven’t reached any definitive conclusions on just what caused the crash, U.S. regulators are contemplating regulatory changes that they believe will help prevent a recurrence. In particular, the SEC is proposing to adopt single-stock “circuit breakers” that would pause trading in certain individual stocks for five minutes if the price moves by 10% or more in a five-minute period. The hope is that this sort of pause “would give the markets the opportunity to attract new trading interest in an affected stock, establish a reasonable market price and resume trading in a fair and orderly fashion.”

These new circuit breakers are to be employed on a pilot basis through Dec. 10, to give the markets time to evaluate, and possibly adjust, the parameters or operation of the circuit breakers based on their experience. Also, application of these circuit breakers will be expanded to include the components of the S&P 500, including ETFs, as soon as practical.




@page_break@It remains to be seen whether Ca-nadian regulators follow suit with their own single-stock circuit breakers. “The Canadian Securities Administrators and theInvestment Industry Regulatory Organization of Canada are currently reviewing the U.S. proposals on the use of circuit breakers,” says Wendy Dey, director of communications with the Ontario Securities Commission. “We are working to identify a response that takes into account the U.S. proposals and is appropriate for the Canadian market.”

Given the number of stocks that are interlisted in Canada and the U.S., it may be hard to justify deviating too far from the new U.S. measures — at least, for the securities that trade actively cross-border.

While the move to introduce these new circuit breakers is the first concrete regulatory response to the flash crash, there are also plenty of other possible changes up for consideration. The SEC says that its staff is also considering ways to address the risks of market orders, and their potential to contribute to sudden price moves.

Among other things, the SEC is considering recalibrating market-wide circuit breakers, which weren’t triggered by the extreme trading action on May 6. The regulator will also study the impact of different trading protocols at the various exchanges, and will continue to work to improve the process for breaking erroneous trades. Finally, the SEC will consider prohibiting the use of “stub” quotes by market-makers; these quotes are not intended to indicate actual trading interest.

As well, the CFTC is considering a rule that would ensure that market participants have equal access to co-location or proximity hosting services offered by futures exchanges. The regulator will also be looking at possible rules to enhance its surveillance capabilities.

The CSA and IIROC say they are conducting their own investigations into the flash crash, including examining a number of electronic trading issues, such as the need to standardize parameters used by stock exchanges and ATSes — in particular, “freeze parameters” that allow venues to freeze trading in specific securities when a significant price change occurs. The Canadian regulators are also reviewing the appropriateness of the existing circuit breaker policy and the trading rules.

While a flash crash that starts in Canada isn’t expected, it’s not inconceivable. A research note from TD Newcrest Capital Inc. indicates the possibility of this sort of crash happening in Canada seems unlikely. For one thing, it notes, “Canada takes its lead from the U.S. market, so it is hard to imagine a made-in-Canada problem.”

Also, the TD note points out, the primary exchange in Canada, the Toronto Stock Exchange, doesn’t have a “go slow” mode like that of the New York Stock Exchange (which is being posited as one of the contributing factors in the crash). There is also more “lit” trading in Canada (less use of dark pools and dark orders) and less electronic trading.

Adds the TD note: “That said, it is not impossible to imagine a similar event, given the marketplace reliance on electronic market-makers for quotes and the lack of proper cross-market freeze mechanisms.”

All of this comes at a time when regulators on both sides of the Canada/U.S. border have already begun grappling with market structure issues. As is becoming clear, these can be hotly contested among the exchanges, alternative trading systems, brokers and investors that operate on the leading edge of this fast-changing part of the financial services industry. About the only thing they all agree on is that the trading business needs a level playing field; it’s just that they have starkly different ideas of what that means. IE