NYSE Makes Rules on the Fly?
Board: Macro Economics
We recently passed the third anniversary of the May 6, 2010 flash crash. You recall when all Hades broke loose. Many stocks, options and futures were affected. Luckily investors that were not watching in real time largely missed the fireworks. As quickly as prices fell, they then rose back to their starting point. All of this occurred in about 30 minutes. One of the lessons learned by individual investors was how rapidly the market could both decline and rise. The Dow was changing at a rate of about 2,000 points per hour. In percentage terms, it was about 10% per hour. There have been many years when the Dow moved less than 10% for the whole year. (Yes, there might have been larger interim moves.)
After the flash crash, the regulators and exchanges got together and implemented a new rule. All trades that were more than 30% “away from the market” were arbitrarily cancelled, aka “busted.” It was just like they never occurred. There were several issues that collapsed to a 1 cent share price during the flash crash. There were a few issues that rose to $99,999 per share. All of these trades were erased and you will NOT see them if you download historical data. If you had a trade that was changed by 29.9%, it was deemed “good” and allowed to stand.
Understand that “busted” trades have been around forever. Someone gets a few numbers backwards or they add an extra digit. In those cases of “clearly erroneous” trades, you are able to cancel the trade after the fact. Both the buyer and seller are NOT given an option. One side was always the big winner while the other side was the big loser.
Under the radar to most investors, “mini” flash crashes have continued to occur. These are typically on one or two stocks at a time, which is why they go largely unnoticed. We see a version of mini flash crashes on REIT preferreds fairly often. In some cases, the trades stand and in other cases they are busted.
Last week on May 23rd, there were flash crashes on two issues: American Electric Power (AEP) and NextEra Energy (NEE). AEP has been around forever with a market cap of about $25 billion. It averages about 2.5 million shares per day. Certainly this would NOT be a likely candidate for a flash crash caused by relative illiquidity.
Unfortunately for AEP, something went wrong at the 9:30 am stock market open on Thursday. AEP closed at 48.50 on Wednesday. It traded as low as 22.28 in the first minute of trading. This is a 54% drop not based on any kind of fundamental business issue.
The NYSE honchos got together and decided that the trades did NOT fall under the “Clearly Erroneous Execution” rule and they let them stand, i.e. they were NOT busted. This is similar to what the NYSE ruled when Knight trading had a slight software problem and did uncontrollable buying at any price. The NYSE must have determined that these trades were NOT caused by a misplaced number, a typo or something of that ilk. Maybe they were caused by an algorithm running on a computer that had a logic fault. In any event, the trades stand as valid. So far so good.
The problem comes after the fact. It seems that the same NYSE honchos that decided to let the trades stand, decided to PERMANENTLY STRIKE THEM FROM THE RECORD! All trades are reported on a system called the “Consolidated Tape” regardless of which exchange a trade was done one. The NYSE instructed the CTA to NOT include these low trades in the high and low statistics that are kept and reported. Go look at your data source for that day. I am willing to bet that it does NOT show the low trades on AEP. I checked five different sources and the reported “low” of the day was in the range of 46.07 to 47.87. Nowhere did I see the 22.28 trades listed.
1) The NYSE has the power to make up rules on the fly and get by with them. How can they possibly rationalize letting the low trades stand, but “erasing” the data? If the trades stand, REPORT the data like it actually occurred. Maybe the NYSE Mensa group was having a separate meeting that day and could not rule on this issue.
2) Some poor investor(s) got killed on these trades. The investor sold AEP shares for 22.28 when the going price was ~ 48.00. Unfortunately, it means you have to use “limit” orders even on a huge market cap, highly liquid issue like AEP. Yes, it is STUPID that you have to do this, but apparently that is what it is going to take to protect yourself.
3) The exchanges and regulators have made progress in preventing flash crashes like this one, but have a long way to go. Yoda’s opinion is that we will continue to see more of the same. It would not be surprising to see a much larger flash crash that affects many issues.
4) One of the ironies is that the “circuit breakers” that are supposed to prevent trades like this are TURNED OFF between 9:30 and 9:45, when this mishap occurred. You better hope your flash crash occurs when the circuit breakers are turned on. . .
CNBC (Gulp!) has the best write-up I have seen so far. 
 CNBC NYSE Lets Volatile Trades Stand But Cuts Them From Tape