Opinion: How to Prevent Another Market Meltdown

(May 9) -- On Thursday, the Dow Jones Industrial Average took a heart-stopping plunge. In less than five minutes, it dropped more than 500 points. This astounding, if brief, descent hit the 1,000-point mark before stocks began to bounce back.

Even worse, the prices of some stocks plummeted to ridiculous levels. Shares of Accenture fell from more than $40 to a penny in just a few moments before recovering. The situation was so extreme that the exchanges were forced to cancel trades in over 200 NYSE-listed stocks.

This unprecedented nosedive highlights an important weakness in our financial system: Our markets are dangerously unprotected against a major glitch like this one.

It's still not clear exactly what caused the drop. Did someone make a mistake and attempt to sell a million shares instead of a thousand? Did a computer program malfunction and start spewing out excessive sell orders? So far no one is confessing to a trading mistake, programming error or machine malfunction.

Was it an unintended side effect of an NYSE procedure that attempted to slow down trading at that time? Or was it a "rogue wave?" From time to time on calm seas, the random summation of many smaller waves sometimes results in a massive one. Was this steep slide just a statistically freakish event in which enough buying interest vanished just long enough to cause a massive disruption?

Eventually we may find out. But we can be sure of one thing: It will happen again. Mistakes are part of human nature. Aberrant events do happen. We could have an even bigger mishap in the future, either as a result of wild chance, human error or deliberate sabotage.

Regardless of what can cause such disorderly trading, our markets should have good safeguards in place to protect investors from such unfair and disorderly trading. Unfortunately, we don't.

Our markets have evolved from places where humans traded with humans to networks in which computers trade with computers. The speed of these computers has outstripped the methods we use in the U.S. to supervise them.

Right now, it's a two-step process. First, computers scan the trading reports for unusual events, such as extremely high volume or large price movements. When something unusual occurs, the computer generates an alert that pops up on the screen of a human analyst. Then that analyst decides what actions, if any, to take. For example, an analyst might decide that recent news explains the change in the stock price and choose to do nothing. Or an analyst might halt trading if it appeared that there was major news about to be disseminated.

That's just too slow.

Our computers trade in milliseconds while humans respond in minutes. Billions of dollars in damage can occur while humans try to figure out what, if anything, they should do.

The current "circuit breakers" that were imposed after the crash of 1987 are too crude to do any good. They shut down the entire market for various lengths of time depending on how much it drops and when. For example, a 10 percent drop in the Dow before 2 p.m. would lead to a one-hour trading halt in all stocks -- even ones that were increasing in value. If it occurred after 2:30 p.m., there would be no halt at all. And these circuit breakers do no good when only a few stocks are affected by a glitch.

The solution is not to slow down our computers, but to speed up our supervision.

We can use computer technology to monitor market quality in real time and to call a trading halt in a stock when the trading becomes disorderly. Then, after humans have had time to analyze the situation and determine that there can be an orderly market, the market would reopen with an auction like it uses at the beginning of trading.

This isn't difficult to do. Germany already uses something like this in Deutsche Börse's Xetra system. The U.S. needs to adopt a similar method for dealing with excessive price movements on a marketwide basis.

Such a system would prevent glitches from turning into catastrophes. It would prevent trades from taking place at such ridiculous prices that the exchanges have to deliberate on whether to cancel them.

Other electronic markets around the world have real-time electronic safeguards against electronic chaos. Why don't we?

The SEC has been slowly studying these issues for some time. Indeed, I testified before an SEC roundtable last year on the need for shock absorbers to deal with such excess volatility. The recent glitch is a signal that we need to take action. If we don't act, the next big glitch could be much worse.

James J. Angel is an associate professor of finance at Georgetown University's McDonough School of Business and specializes in the structure and regulation of financial markets around the world.


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