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Investors Punished by Never-Ending Flash Crashes

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On November 29, 2012 shares in a security linked to satellite operator Iridium Communications (NASDAQ:IRDM) rose about 14,000% after set of trades in the $14 stock spiked to roughly $2000 on Nasdaq (NASDAQ:NDAQ).

That obviously flawed stock quote -- along with similar big price swings in NYSE-traded ETF's like the SPDR Barclays Convertible Securities (NYSEARCA:CWB) and the Direxion Daily Mid Cap Bull (NYSEARCA:MIDU), RLJ Lodging Trust (NYSE:RLJ), Kraft Foods (NASDAQ:KRFT) and Enstar Group (NASDAQ:ESGR) -- are among thousands of examples of high frequency traders violating post-Flash Crash regulations, according to Eric Scott Hunsader, the founder of Nanex, a market data provider.

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The same destabilizing trading behavior is seen in big name, high volume stocks like Google (NASDAQ:GOOG), when volatility created by unexpected news events moves shares in a Flash Crash-like manner, Hunsader says. He often highlights those trades on Twitter and Nanex's web site.

The culprit is the so-called 'stub quote,' a sort of placeholder trade that can also test the price of a stock without committing money. The problem is stub quotes were banned by the Securities and Exchange Commission after the 2010 "Flash Crash but - according to Hunsader and other stock market watchers - they continue to cause wild stock swings.

According to the SEC's definition, a stub quote is "an offer to buy or sell a stock at a price so far away from the prevailing market that it is not intended to be executed, such as an order to buy at a penny or an offer to sell at $100,000."

In the past, the practice stub quotes was considered an innocuous way for market makers to maintain quotes in stocks they didn't want to trade. However, in the wake of the Flash Crash stub quotes were highlighted by SEC chair Mary Schapiro as a key culprit of the day's trading volatility - for instance Apple's (NASDAQ:AAPL) surge to roughly $100,000 a share and trades in Boston Beer Company (NYSE:SAM) and Accenture (NYSE:ACN) as low as a cent. Recent allegations of market manipulation indicate stub quotes and trade cancellations are part of illegal strategies such as 'spoofing' and 'layering.'

In the Flash Crash, exchanges were forced to cancel thousands of trades at prices deemed erroneous when a lack of real bid and ask offers caused stub quotes to be executed. The prohibition now forces market makers to hold bid and ask offers no further than 8% away from the best reported price of a stock, and no more than 20% away at the market's open and close.

While the stub quote may seem like just more Wall Street inside baseball the can end up hurting retail investors. Some trades stood in the Flash Crash and in similar instances since, causing real investor losses. The crash is also seen as eroding investor confidence and causing chronic outflows from stock markets.

In addition, mini-Flash Crashes raise wider questions about the strength of enforcement on post-crash rules and the fragmentation of regulation.

While the SEC and exchanges highlight the stub quote ban and a regulation called the Market Access Rule that casts a wider net of regulation over dark pools and high frequency traders as key regulations, much of the enforcement of those rules actually resides with FINRA, an industry appointed regulator.

Many exchanges have outsourced the enforcement of opaque over-the-counter trading at the heart of the crash to FINRA. Meanwhile, the SEC's involvement with post-Flash Crash regulation appears to involve codifying rule proposals, and doing an occasional look-over-the shoulder of FINRA enforcement, according to industry watchers.

In spite of the frequency of inexplicable trading blips in the two years since post-crash rules were implemented, few large penalties have been issued for using stub quotes. In fact, exchanges and regulatory agencies appear to react to prohibited trading as they did in the past.

Notably, exchanges simply break irregular trades without imposing any penalties, such as the 14,000% stock gain of the Iridium-linked security through clearly erroneous execution policies, a move Nasdaq spokesperson Wayne Lee confirmed to TheStreet.

Thomas Gira, a FINRA executive charged with market regulation, told TheStreet in an interview that the agency checks feeds of erroneous trades for patterns that indicate stock market manipulation or weak procedures. Reviews sometimes indicate a broker is non-compliant with the stub quote ban or rules preventing destabilizing market orders and can lead to immediate enforcement actions.

Still, according to Gira's comments, most of FINRA's post-crash work currently centers on more routine reviews of brokers systems and compliance policies in over-the-counter markets, such as so-called 'dark pools' and 'internalizers,' where the lions share of high frequency trading occurs.

According to Gira, a failure of those reviews is currently likely to result in an 'action letter' that outlines regulatory deficiencies to be fixed over immediate enforcement actions, given the novelty of post-crash regulations such as the Market Access rule.

If a broker continues to have compliance issues, or their deficiencies result in an adverse market impact, "that would be an issue where formal action may be warranted," Gira adds, while noting failures of second reviews may draw enforcement.

A check of 2012 enforcement actions posted by FINRA shows few instances of monetary or regulatory sanctions against a firm that appears to be breaking post flash crash regulations such as the Stub Quote or Market Access rules.

Recent FINRA settlements also indicate serious allegations of market manipulation and post-crash rule breaking only warrant minor fines.

For instance, a late September fine brought by FINRA against Title Securities alleged the Chicago-based broker facilitated the unchecked and manipulative trading of its sole customer, Cyprus-based high frequency trading firm Hainy Investments.

While FINRA's complaint alleges Hainy Investments was able to use Title Securities to trade as much as three billion shares a month, oftentimes in a manner that used banned trading techniques to manipulate stock prices, the agency merely censured the brokerage and fined it a paltry $37,500.

According to FINRA's allegations, Title Securities lacked anti-money-laundering compliance and had no surveillance on trades the firm brokered -- rule violations that ultimately led to the manipulation of stocks through erroneous trades.

"FINRA also found that the firm received numerous inquiries from its clearing firm, as well as from FINRA, BATS, NYSE ARCA and NASDAQ concerning wash trading, odd lots and layering in the customer account. Despite being placed on repeated notice of potentially manipulative trading in the customer account, the firm failed to establish meaningful controls," the complaint states.

"The firm never considered whether to file a [suspicious activity report to FINRA] related to any suspicious trading activity identified, even in the instances where the firm instructed the customer's authorized representative to terminate the customer account trades for their questionable trading activity," FINRA adds.

According to a press release posted to NYSE's Web Site, Title Securities' registration remains active and there's no indication of any SEC involvement. The firm didn't admit wrongdoing in its settlement.

The fine may signal the costs of a fragmented enforcement of post-flash crash regulations.

In another late September enforcement action, the SEC, FINRA, Nasdaq and BATS Global Markets fined brokerage Hold Brothers On-Line Investment Services a total of $5.9 million for allowing an overseas trader to enter U.S. markets unchecked and allegedly manipulate stock movements.

The complaint indicates a violation of the spirit of post-crash regulations such as the Market Access rule.

Hold Brothers is alleged to have used 'spoofing' of bids outside of a National Best Bid or Offer - mandated by the Stub Quote rule - to manipulate valid orders in some stocks artificially higher and profit from an opposing position. The firm was also accused of 'layering' limit orders outside of National Best Bid or Offer [NBBO] rules to create the appearance of a change in the levels of supply and demand of a stock, artificially moving prices.

In both alleged violations, trade cancellations appear at the heart of the market manipulation.

"FINRA uncovered hundreds of instances where the foreign day traders used spoofing and layering activities to induce the trading algorithms of unwitting market participants to provide the traders with favorable execution pricing that would not otherwise have been available to them in the absence of the day traders' illicit spoofing and layering activities," the agency states in the Sept. 25 settlement, in which Hold Brothers neither admitted or denied wrongdoing.

As part of the disciplinary action, FINRA and the exchanges also ordered Hold Brothers to conduct an independent review of the firm's compliance with various trading laws. The SEC's settlement barred three Hold Brothers senior managers from trading.

In investigating the root cause of inexplicable stock movements like the 14,000% rise in the Iridium-linked security, TheStreet contacted major U.S. stock exchanges, FINRA and the SEC, who initially declined to comment on the record, leaving many basic questions on enforcement unanswered.

After a correspondence, NYSE spokesperson Keara Everdell allowed FINRA's Gira to discuss how th agency goes about work contracted from the exchange.

Two exchange executives, who weren't authorized to speak on the record, and Gira of FINRA expressed confidence that as rules such as Market Access become entrenched and new rules are implemented, erroneous trading is likely to decline sharply.

One exchange executive noted the Market Access rule sets clearer precedent against manipulative or irregular trading, and holds brokers more accountable for a wide range of possible violations.

Another exchange official pointed to soon to be implemented 'limit up-limit down' rules as providing a kill switch that could preemptively stop erroneous executions before they happen.

Gira of FINRA echoed those sentiments and added that because most brokers under FINRA's jurisdiction now face second reviews, future rule violations are more likely to lead to sanctions. He also expressed confidence that a next set of post-crash rules will further arrest erroneous trading and help to stabilize markets.

"The probability of [another Flash Crash] occurring is much lower than it was before. The market has been shored up because of single stock circuit breakers and should be further supported by the limit up and limit down process that becomes effective next February," says Gira.

Hunsader of Nanex gives exchanges, FINRA and the SEC credit for reducing the number of what he sees as stub quote trades by way of post-crash regulations. Nevertheless, he sees countless violations since the rule's enactment and questions whether some policies such as trade cancellations facilitate rule breaking.

"They shouldn't cancel any ofthe tradesbecause then there is no incentive to improve," says Hunsader of high and low trade executions that could cause losses large enough to dissuade traders from holding out stub quotes.

While the most abnormal trades are normally cancelled, some irregular trades within erroneous parameters stand and raise the prospect of unwarranted gains and losses. The Iridium-linked security closed Nov. 29 trading 12% higher, after only changing hands a half dozen times in the month. Some ordinary investors were left holding big losses in the wake of the May 2010 crash.

Currently, the SEC is undergoing changing of guard as the likes of chair Mary Shapiro and Markets Director Robert Cook leave the agency. In the interim, Schapiro will be replaced by Elisse Walter, a current SEC commissioner. The SEC, who credits Cook as having been a key figure in the agency's flash crash response and implementation of circuit breaker, erroneous trade and limit-up/limit-down rules, is yet to name his replacement.

The Iridium-linked security's 14,000% surge and many other similar erroneous trading instances signal that regulators have work left to do in responding to the root causes of the flash crash.

Exchanges and industry-appointed regulators like FINRA also need to state in more clear terms how post-crash rules are being enforced, and show better results if erroneous trading continues in the New Year.

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