Market Regulators Failed to Heed Own Warnings

NEW YORK (TheStreet) -- As regulators reveal more about their probe into the May 6 market mayhem, it is becoming increasingly clear how ill equipped they are to do their jobs.

Tuesday's testimony of officials from the regulatory agencies and exchanges is rife with details about unusual stock levels, outsized trading volumes and unprecedented percentage swings. Yet despite all the data presented, no definitive answers emerged.

While investigators continue to examine the roles of individual firms, the potential for erroneous trades, questionable market access standards and the differing rules governing various exchanges, the only conclusion that can be drawn so far is that regulators can't keep up with today's fast-paced digital markets.

That's bad enough -- what's worse is they knew it all along.

'The Real World' -- White House Edition (Forbes)

Beginning in mid-January, with the Securities and Exchange Commission's move to conduct a broad review of the structure of the equity markets right through to a decision just two days before the meltdown to have the Financial Industry Regulatory Authority assume control of market surveillance and enforcement for the New York Stock Exchange, regulators had begun a slow march to head off big risks in a market whose complexity had grown exponentially in recent years.

It took a nearly 1,000- point crash for the Dow and an afternoon of market mayhem for investors on May 6 to create a real sense of urgency for regulators.

"The market's precipitous decline riled investors and highlights the need for regulators and exchanges to ensure that effective safeguards are in place," said Amy Borrus, deputy director of the Council of Institutional Investors, a nonprofit organization of public, union and corporate pension funds with combined assets that exceed $3 trillion.

The key word in the above quote is "effective." The markets obviously have safeguards in place, but in this case they weren't up to snuff. The move to create a single regulator for surveillance and enforcement on May 4 was a step in the right direction but it looks like a case of too little, too late.

The inability of regulators to say exactly what happened has vexed a public hungry for an explanation of the gyrations that caused the cancellation of trades in hundreds of stocks. More than 10,000 trades were canceled on the Nasdaq alone, according to the prepared testimony of Eric Noll, an executive vice president with Nasdaq OMX Group(NDAQ).

The lack of a single regulator, along with the dizzying speed that trades can be executed, means it's nearly impossible to put together a comprehensive audit trail for order and trade information. It's a situation that regulators have been nervous about for months because they can't keep up with the trades and they can't always tell who is making them.

Previous efforts to adapt regulations to the evolving digital marketplace failed to consider all the ramifications. Consider Regulation NMS, introduced in 2005 to open up the markets and improve liquidity with electronic trading. The rule allowed trades to flow through to other exchanges even when the NYSE decided to slow things down.

"I don't think anybody had really thought through carefully enough how the electronic exchanges would react if the NYSE wasn't there to support the bid in a timely manner," says Peter Hagan, a managing director at global consulting agency LECG and a former Merrill Lynch executive, referring to the NYSE's liquidity replenishment point mechanism, which kicked in on May 6 and slowed trading in a number of issues, arguably adding to the market's volatility as orders were dispersed to other exchanges.