This is a great example of how a simple act by government can, on the surface, seem fair and beneficial. But if we take the time to look beyond the immediately obvious effects, to the less obvious, to the indirect effects, and to the way in which the act alters incentives for behavior in the future, we find that it has effects which are significant, harmful, and unfair.
EXCERPTS:
"... the Dow Jones Industrial Average plunged more than 600 points in less than 15 minutes, baffling and unnerving investors. Amid the chaos, algorithmic trading shops, or algos, that rely on rapid, computer-based automated trading in theory could have provided much-needed liquidity. Instead, they stayed largely on the sidelines....
And even those traders who waded into the selloff to provide liquidity may have found themselves penalized as a result. Trades subsequently deemed erroneous were later broken, potentially creating money-losing positions at high-frequency trading shops.
Late Thursday, the exchanges decided to cancel all trades involving swings greater than 60% of a stock's consolidated 2:40 p.m. price. That erased all orders made when a stock dipped to irrationally low prices. But it didn't erase the trades that occurred when the market rebounded. The New York Stock Exchange said that about 4,000 trades were broken Thursday after being identified as clearly erroneous as per exchange rules.
A trader who stepped in and bought a stock that was tumbling could be left unexpectedly owing shares in what is known as a short position. For example, if a stock was trading at $60 a share, but was sold for $10, the trader who bought it at $10 and then sold it later for $50 when the market rebounded would be left holding the shares short at $50, with his previous profit wiped out.
That put those who might have stepped into mitigate the freefall in a bind and left the market open to its rapid descent.
"If in fact they're responding to a true economic disaster, they will buy stock and it will continue to go lower. But if they're responding to a mistake or an overreaction and they buy, they mitigate the freefall," but end up getting penalized for it, said Dick Rosenblatt, chief executive of Rosenblatt Securities. "In this case, the stock rallies and they sell out their position for what they believe to be a profit. In fact after the trade is broken, they end up with a short position and they will again lose money. In either case, in a fully automated market, we have disincentivized liquidity providers from entering the market to limit volatility when we need them most."
