SEC's Schapiro: Did Market Makers Meet Obligations On May 6?

The Securities and Exchange Commission is examining the behavior of market professionals during the puzzling May 6 stock plunge to determine whether they met their legal obligations to investors, SEC Chairman Mary Schapiro said Thursday.

"If we identify any activity that violates the securities laws, we will take appropriate action," Schapiro said in written testimony prepared for the Senate Banking Committee's Subcommittee on Securities, Insurance and Investment.

Thursday's congressional hearing is the second in as many weeks on the market "flash crash," when the Dow Jones Industrial Average sank nearly 1,000 points before staging a partial recovery. Policy makers and market analysts are clamoring for information about what happened and how to stop a similar event from occurring again.

"I am deeply concerned about the effects that this volatile market had on investors, especially retail investors," Schapiro said.

The SEC has received numerous complaints from investors who had "stop-loss" orders in place to protect against falling markets, she said. Those accounts were liquidated as stocks were plummeting on May 6, "only to have stock prices close significantly above their sale prices."

To keep such a plunge from occurring again, the SEC and the major trading exchanges will implement a cross-market "circuit breaker" in June that will require a five-minute time-out for any stock that sees a 10% change in price in the preceding five minutes. Other fixes, such as a marketwide pause and unified trade-cancellation policy, also are in the works.

The SEC is asking whether the exchanges' decisions to break trades that occurred during the volatile half-hour period were applied "fairly and consistently among investors," Schapiro said.

The SEC also is investigating market participants to ensure that they met their "best execution obligations" during a mass selloff, Schapiro said.

Preliminary findings from regulators about the flash crash indicate that it was caused by a "severe temporary liquidity failure" and not any economic factor indicating that equities "truly could drop and recover such a large amount in just a few minutes," Schapiro said.

Schapiro's testimony for Thursday's hearing echoed her comments given a week earlier before a House panel when she said regulators found no evidence that a "fat finger" typing error or hacker or terrorist activity caused the flash crash.

Schapiro also referenced findings from a joint report on the crash that the SEC issued earlier this week with the Commodity Futures Trading Commission.

The Financial Industry Regulatory Authority is working closely with the SEC and CFTC in its investigation. Finra Chairman Richard Ketchum said in testimony that his staff is focusing on about 300 stocks that experienced the most dramatic declines during the 30-minute plunge-and-recover period. Those stocks coincided with securities that were the subject of cancellations and reversals after the May 6 incident, he said.

The SEC will be taking a closer look at the May 6 activity around exchange-traded funds, hybrid funds that have shares traded throughout the day, Schapiro said.

ETFs were affected more than any other securities class by broken trades, Schapiro said. The SEC is investigating institutional investors' practice of shorting ETFs to hedge against broad market exposures, asking whether those shorts contributed to certain ETFs' dramatic intraday price swings.

The SEC also is looking into exchanges' "self-help" practices. SEC rules require exchanges to route orders to the exchange that has the best price. But an exchange can occasionally enter self help and waive that rule if it perceives unusual activity at another exchange, allowing it to stop sending orders to that venue.

Nasdaq OMX Group Inc. (NDAQ) and BATS Exchange declared self help against the NYSE Euronext's (NYX) electronic trading platform Arca in the minutes before 2:40 p.m. on May 6. Schapiro said the SEC is looking into whether there needs to be "greater consistency in exchange practices with respect to the self-help mechanism."

CFTC Chairman Gary Gensler and officials from the major exchanges also were slated to testify. Gensler said in testimony that an algorithm used when a single trader sold a large number of stock index futures on May 6 may have caused an unintended impact because the market lacked liquidity.

Eric Noll, executive vice president of transaction services for Nasdaq, said the changes proposed by regulators will help the exchanges be consistent in responding to market trends.

NYSE Chief Operating Officer Larry Leibowitz said regulators shouldn't "point blame" at professional traders or certain liquidity providers and should focus instead on the role of market makers and alternate trading platforms such as "dark pools."

Terrence Duffy, executive chairman of CME Group Inc. (CME), a futures market, said lack of consistency in equities markets excacerbates problems in times of market stress.

-By Fawn Johnson, Dow Jones Newswires; 202-862-9263; fawn.johnson@dowjones.com

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