Did market manipulation cause Wall Street 'flash crash?'

The Securities and Exchange Commission is keeping a close eye on a stock market practice that may violate rules against market manipulation, the Wall Street Journalreported yesterday. The practice, called “quote stuffing,” happens when stock exchanges are flooded and, at times, clogged by huge numbers of buy and sell orders—orders that are ultimately cancelled.

Regulators are trying to determine if traders are using rapid-fire computerized trading systems to cause the inundation by design, purposefully gumming up the exchanges and giving traders an information advantage on small price movements in stocks.

The Journal reported that the SEC is investigating whether quote stuffing may have been one of the causes of the May 6 “flash crash,” when the Dow briefly plunged 1,000 points in a matter of minutes.

To get an idea of the volume of quotes produced by high-speed, computerized trading, consider this: During the day of the flash crash, “there were hundreds of times that a single stock had over 1,000 quotes from one exchange in a single second,” according to Nanex, a ticker of quotes and trades.

Or, for the visual learners out there, take a look at Nanex’s mesmerizing, time-delayed video clip that flashes all of the quotes for one stock, in this case Public Storage, in just one second.

If quotes from various exchanges clog the system, as the New York Stock Exchange admittedll happened during the flash crash, some traders could profit. Nanex’s report explains why quote-stuffing could represent market manipulation:

“Competition between [high frequency trading] systems today has reached the point where microseconds matter. Any edge one has to process information faster than a competitor makes all the difference in this game. If you could generate a large number of quotes that your competitors have to process, but you can ignore since you generated them, you gain valuable processing time.”

But saying there could have been manipulation isn’t the same as proving there was. The factors that caused the crash are up for debate. The Journal reported that not everyone agrees with Nanex’s conclusions:

“Others say the canceled orders are above board, reflecting either legitimate behavior by traders in search of profitable trades, basic market-making, where broker-dealers constantly provide quotes for potential trades and then cancel, or computer programs gone awry.”

The SEC and Commodity Futures Trading Commission are expected to issue a report later this month.

-- Karen Weise, ProPublica