UPDATE: CFTC's Gensler Outlines Possible Reforms Following `Flash Crash'

The head of the Commodity Futures Trading Commission laid out possible regulatory responses Monday to the May 6 "flash crash," saying the use of an automated trading program by a large trader contributed to market events.

CFTC Chairman Gary Gensler's remarks come just a few days after the CFTC and Securities and Exchange Commission released a joint report Friday examining the causes of the flash crash.

The report pointed to a single trade by a large mutual fund in the E-mini Standard & Poor's 500 futures contract as one cause for sending stocks plunging. The large trader and its broker opted to execute a large sell order of 75,000 contracts all at once through an automated algorithm in a move that left the market without enough buyers to absorb the trades.

The algorithm was used in lieu of human traders and it was designed to sell contracts at a pace of up to 9% of trading volume without taking into account other factors. Due to market conditions that day, the contracts were sold in a matter of only 20 minutes even though it would take five hours on a normal day. Gensler said he viewed the trade as "somebody putting a $4 billion order into a fragile market on autopilot without regard to price or time."

"One key lesson is that, under stressed market conditions, the interaction between the automated execution of a large sell order and trading algorithms can quickly erode liquidity and result in disorderly markets, especially if algorithms use volume as a proxy for liquidity," Gensler told the audience. "The events of May 6 demonstrate that, in volatile markets, high trading volume is not necessarily a reliable indicator of market liquidity."

Gensler said Monday the large trader and its executing broker made a series of choices that day which helped lead to market events, and he questioned if brokers should be subject to new rules and obligations.

"On May 6--as is often the case--the large customer did not execute the trade itself, but used an executing broker," Gensler said. "Should executing brokers have to adopt certain trading practices when executing a large order by use of an algorithm, such as price or volume limits?"

Gensler said some of the obligations for brokers that could be considered are the same kinds of requirements currently in place for exchanges, such as curbs on the maximum size of an order and other price bands. He also questioned whether both brokers and customers should have an "obligation to monitor and make non-disruptive trading judgments."

Under the Dodd-Frank law, the CFTC has broad new powers to police "disruptive trading practices." The law makes it easier for the CFTC to take enforcement action because it no longer requires lawyers there to prove that a firm intended to violate the orderly execution of orders. Instead, the CFTC could bring a case if the agency can prove a firm acted recklessly.

Rules on disruptive trading haven't been implemented yet and Gensler said the staff is still drafting them. He didn't say if the actions by the large trader and its broker on May 6 could eventually be considered a type of disruptive trading practice in the future. But he indicated the agency may look closely at the flash crash events as it crafts the new rules.

"We're all informed by the events of May 6 and looking at the new requirements in statute of disruptive trading practices through this new lens and how algorithmic transactions are entered into the market," he said. "But I couldn't tell you what we'll do."

Other market structural areas that could be improved, Gensler said Monday, include the transparency of the order book, or the public listing of bids and offers. Right now, he said, traders can only see up to the tenth offer or bid in an order book and that they could benefit from greater visibility.

"One of the problems on May 6 was that a large sell order overwhelmed existing liquidity in the E-Mini order book," he said. "Might fuller visibility of the order book lessen the chance of market disruptions resulting from such large buy or sell orders in the future?"

One thing the flash crash report found Friday was that the use of a trading pause mechanism by CME Group Inc. (CME), which lists the E-mini, helped balance the market and restore liquidity. This mechanism, known as stop logic functionality, initiated a five-second trading pause.

Still, Gensler said regulators should also consider potential revisions to trading pauses in the wake of the flash crash.

"On May 6, the E-Mini stopped trading for five seconds. This was a critical moment in the markets. The pause gave the order book time to replenish," he said. "Would it have been better if the pause came earlier? If so, what conditions should trigger a pause? Should cross market circuit breakers be adjusted from their current 10% limit?"

The report Friday didn't make any of the suggestions Gensler laid out in his speech Monday at a conference in Washington on swaps trading. But the report will now go to a joint SEC-CFTC advisory committee, which will make recommendations.

Gensler said the ideas he outlined are all things he hopes the committee will discuss and consider.

-By Sarah N. Lynch, Dow Jones Newswires; 202 862 6634; sarah.lynch@dowjones.com

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