CME's Donohue: Flash Crash Fixes Only Compound Market Issues

The top executive of CME Group Inc. (CME) warned U.S. regulators that "flash-crash" fixes for the stock market are headed down the wrong path, and that new securities trading rules should be modelled on the futures market.

A lack of coordination between stock and futures exchanges in times of turbulent trading will make it harder for investors to continue doing business and may exacerbate market movements, CME Chief Executive Craig Donohue said.

"One key lesson of the events of May sixth is that closely linked markets should have coordinated halting mechanisms, yet the single security circuit breakers actually undermine that principle and have the potential to exacerbate disruptions across related markets during significant market events," wrote Donohue in a letter to U.S. securities and derivatives authorities.

A push to replace the circuit breakers for stocks with less-disruptive "limits" on price moves--modeled on existing practices in futures markets--will only add "yet another layer of complexity" and create new headaches, Donohue said.

Regulators, exchanges and brokers continue to work on new structures for trading in U.S. financial markets nearly a year on from the flash crash, when stock indexes plummeted in a matter of minutes, prompting more than 20,000 trades to be cancelled and rattling investor confidence. A system of circuit breakers, temporarily halting trade in volatile stocks and exchange-traded funds, was implemented alongside stricter rules for voiding trades.

Securities exchange executives including Nasdaq OMX Group Inc. (NDAQ) CEO Bob Greifeld have stated that a repeat of the flash crash on May 6 couldn't happen thanks to the new safeguards. But CME, operator of the world's largest futures platform, has warned that the new rules have made U.S. markets more fragile because they don't account for the way electronic traders blend stocks, options and futures.

Should another flash crash strike, the halting of multiple securities at different times would create confusion around the value of indexes, which underlie some of the most heavily traded futures and options contracts, Donohue wrote. If traders have a hard time laying off their risk in derivatives markets, they will be less likely to trade in volatile stocks, leading to the same sort of drought in liquidity that sent markets diving on May 6.

"CME Group is not aware that the impact of the single security circuit breaker regime has been effectively modeled in the context of a May 6th type of scenario, and it appears to us to be risky and misguided to have implemented such an approach without fully understanding the unintended and potentially harmful consequences that might occur as a result," Donohue said.

He advised against the joint committee's recommendation to broaden the circuit breakers to cover all but very lightly traded securities, and warned that a new "limit up-limit down" approach being considered could lead to new problems, particularly in trading options contracts.

CME's approach of electronically verifying the price and limiting the size of incoming orders should be taken up by stock exchanges, alongside the company's own method of shorter trading pauses for jittery contracts, Donohue said.

Separately, the joint committee's recommendation that high-frequency trading firms bear greater costs associated with entering and rapidly cancelling orders would amount to a "tax" on U.S. markets' busiest customers, according to the letter.

"Inappropriately taxing order cancellations could well prove counterproductive and harm market stability," Donohue said.

-By Jacob Bunge, Dow Jones Newswires; 312-750-4117; jacob.bunge@dowjones.com

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