By John J. Conklin III

There was no error or "fat finger" that caused Thursday's market crash. The cause was Regulation National Market System (Reg NMS), Congress and the Christopher Cox Securities and Exchange Commission. They sold their souls to the "speed-of-execution guys," and as you know, speed kills!

Based on the CNBC interview with NYSE Euronext ( NYX) CEO Duncan Niederauer and my own experience in electronic markets and on the NYSE, this is what happened:

As the market started going down, there was an influx of sell orders in Procter & Gamble ( PG - Get Report). The specialist has the option, under certain circumstances, to "go slow," meaning to turn off the electronic execution and find a fair price for the sell orders.

This enables buyers to respond to the imbalance. However, the other trading venues and exchanges are not required to go slow and are not required to trade with quotes on the "slow" exchange. So what happened was that during this NYSE slow time a market order for as little as 100 shares hit another exchange and went looking for a bid to hit. It found the bid, but it was down more than $10! This totally disregards that the NYSE may have had a $56 bid for 10,000-plus shares, but in the interest of collecting the pennies for the execution, they would match at $49.

How can this happen? My answer is Reg NMS, which the SEC proposed in late 2004 to overhaul the national market system.
  • Reg NMS forced all liquidity into dark pools. There are no bids/offers on these books other than those around the current price. In addition, these bids are very small. The reason is that the algorithms can decipher the interest at certain levels. All market participants never show a substantial bid/offer because the high-frequency traders will pick them off or penny them. All major liquidity is in dark pools.
  • Reg NMS destroyed the specialist system. Even though the specialist system had its flaws, specialists made up to 10% of market liquidity. Currently they make up closer to 1%. That liquidity was lost forever.
  • Reg NMS created a new industry: high-frequency traders. Their objective is to make pennies and collect the rebate. They don't add value. And be rest assured that if you have a real order in the market, their algorithms will trade against it. Reg NMS created a business that adds no value but has 70% market share and takes advantage of the individual investor.
  • Reg NMS does not allow the markets to slow down in times of panic. It exacerbates meltdowns because it allows other exchanges to trade through the "slow" markets even if the "slow" markets have the superior price.
  • Reg NMS does not require an individual investor's entire bid to be displayed. As a result, I have had a bid at $45 with a broker but the stock was trading below that level on another exchange. How does that happen? Well, the handling broker wants to collect the rebates for both sides of the trade so he does not display the bid -- and hopes that the investor does not notice that he may have missed the market!

As to the Procter & Gamble fiasco, the algorithms and high-frequency programs accelerated the decline because they needed to catch up. This caused a disruption in all of the stocks.

The NYSE and Nasdaq are going to cancel the trades that were down 60%. What about the trades in the other stocks that were down 30%? What about the stops that were elected?

I do not have the answers, but I know the root cause: Reg NMS.

John J. Conklin III is now a private investor.

From 2004 through 2007, he was the president of the third largest specialist firm on the New York Stock Exchange trading floor. Before leaving, he helped to oversee the conversion of the firm's specialist system to an electronic platform in compliance with Regulation NMS. In addition, he worked with the NYSE and NYSE Regulation in implementing the NYSE hybrid system.

In 2007, Conklin was a NYSE governor and a member of the NYSE Market Performance Committee.

At the time of publication, Conklin did not have a position in Procter & Gamble.

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