Investors Punished by Never Ending Flash Crashes

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

That obviously flawed stock quote -- along with similar big price swings in NYSE-traded ETF's like the SPDR Barclays Convertible Securities ( CWB) and the Direxion Daily Mid Cap Bull ( MIDU), RLJ Lodging Trust ( RLJ), Kraft Foods ( KRFT) and Enstar Group ( 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.

The same destabilizing trading behavior is seen in big name, high volume stocks like Google ( 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.

One 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 ( AAPL) surge to roughly $100,000 a share and trades in Boston Beer Company ( SAM) and Accenture ( 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 excluding the NYSE 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, they 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 regulations were implemented, few large penalties have been issued for rule violations. 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 lion's 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.

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