Are equity markets vulnerable to a sudden collapse if the traders who account for about half of the volume have no regulatory obligations to stabilize prices? After the "Flash Crash" of May 6, 2010, policymakers have resoundingly answered this question in the affirmative. During the worst of the crash, some of the so-called high-frequency trading firms that dominate equity markets stopped trading and prices collapsed, momentarily wiping out almost $1 trillion in market value. In response, the U.S. Securities and Exchange Commission is considering whether high-frequency trading firms should be required to act as the traders of last resort. This Note argues that the regulation under consideration would likely result in higher transaction costs without ensuring market liquidity or stability. This Note proposes instead that the largest high-frequency traders be subject to heightened regulatory oversight to ensure fair dealing.
In twenty minutes on May 6, 2010, stock market investors lost about $862 billion.1 Fifteen minutes later, the market had surged back to recover almost all of it losses.2 It was the worst intrady pint drop on record for the 114-year-old Dow Jones Industrial Average.3 Individual investors who sold their stock during the worst of the panic may have lost more than $200 million relative to the closing price for the day.4 The so-called "Flash Crash" rattled investor confidence, sparking eight consecutive months of withdrawals from U.S. stock mutual funds for a total of almost $90 billion.5 Regulators and investors alike concluded that equity markets had simply failed.6
Exchanges are supposed to reduce the cost of searching for the best price by establishing a venue where buyers and sellers meet and compete for trades.7 A single meeting place for traders helps develop prices that reflect the relevant information about the underlying economic value of a security.8 Yet when needed most on May 6, exchanges failed to provide liquidity at a fair price.9 More than 20,000 trades for some 300 securities were cancelled on May 6 because they were executed at "clearly erroneous" prices.10 Since May 6, there have also been periodic reports of similarly sudden breakdowns in the markets for certain securities." Such extreme volatility hinders capital formation by raising the cost of equity capital for companies.12 As noted by one executive of a company whose shares plummeted on May 6, events like the Flash Crash deter investments in otherwise strong businesses merely because their shares are vulnerable to a market malfunction.13
This Note analyzes some of the proposals aimed at preventing another Flash Crash in equity markets. In particular, it examines whether the Securities and Exchange Commission (the "SEC," or the "Commission") should require high-frequency trading firms ("HFTs") to act as the buyers or sellers of last resort.14 This could entail two kinds of requirements: an affirmative obligation to stand continuously ready to buy and sell a stock, and a negative obligation to refrain from trading in certain circumstances. Currently, only market makers have such obligations.15
The Commission first suggested these obligations in January 2010, when it issued the Concept Release on Equity Market Structure with three dozen proposals to address issues arising from the growth of electronic trading.16 The SEC noted that although HFTs dominate equity trading, they can withdraw from the market at any moment since they are not subject to the same obligations as market makers.17 The SEC also stated that some HFT strategies fuel volatility and may even border on illegal manipulation.18 Public comments in response to the Concept Release focused on the SEC's far-reaching proposals to regulate HFTs.19 The Flash Crash greatly intensified the political pressure on the SEC to rein in HFTs.20
Proponents of imposing market maker obligations on HFTs claim that they would stabilize the market in times of stress. …