Analysis: Is U.S. stock trading safer? Fewer erroneous trades seen

The water may be safer than many investors thought.

More than three years after the "flash crash" terrified many by temporarily wiping out almost $1 trillion of U.S. stock market value in a few minutes, there are signs that the number of erroneous and aberrant trades is dropping.

The use of circuit breakers for individual securities in the wake of the May 6, 2010 plunge, and the introduction of tougher risk-management controls for broker-dealers in November 2010 appear to have helped stabilize trading, market experts and regulators said.

The Financial Industry Regulatory Authority, the security industry's watchdog, said the number of reports of "clearly erroneous" trades it received was down 84 percent in the last six months of 2012 compared with the first six months of 2009.

"We have seen a dramatic reduction," Richard Ketchum, chairman and chief executive of FINRA, told the Reuters Global Wealth Management Summit last week, though he acknowledged there were still plenty of such incidents.

The signs of greater stability may help bring some smaller investors back into the market. Many had left after losing their shirts in the stock market slide during the financial crisis, and many have missed out on the recovery in the years since. Perceptions that it is a scary place where an investment can seemingly be wiped out in minutes for no fundamental reason were reinforced by the flash crash as well as other episodes of turmoil.

There are, though, still concerns that electronic trading is causing or amplifying price distortions when they occur.

Exchange circuit breakers, which are being upgraded, resulted in a temporary pause in trading for five minutes if shares of a large-cap stock moved 10 percent or more within a five-minute period, not including the opening minutes of trading. The idea is that a cooling off period will allow investors to discount disorderly or erroneous trading and a more normal trading pattern can resume.

The U.S. Securities and Exchange Commission began bolstering the trading pauses in April with new limit up/limit down rules, which include a 15-second buffer to see if prices revert after a single trade sends a stock inexplicably lower or higher. That short pause will happen before a trading halt is declared.

FINRA also monitors clearly erroneous trades to see if there is a pattern by the brokerage handling such trades, which may prompt a review of that firm's order entry controls.

The circuit breaker program has been an effective safeguard and the brief disruptions outweigh the risks of not having such protections, said Ana Avramovic, an analyst at Credit Suisse who specializes in electronic trading.

"Our whole point is that the number of triggers may look high, but no one cares at all about most of them," she said.

This doesn't mean that there aren't still very frightening moments for traders and investors.

In the last minute of trading on May 17, shares of oil producer Anadarko Petroleum sank to just one penny a share from $90, briefly reducing a company with a market value of $44 billion to just $5 million.

It was the latest of seemingly inexplicable price drops and spikes often caused when market makers, who take the other side of a trade, step back because of perceived unusual trading.

All trades below $87.56 a share were ultimately canceled by the New York Stock Exchange, a unit of NYSE Euronext . FINRA will look at whether there was a failure in controls in the Anadarko case, as it does in other mishaps, Ketchum said.

Unexpected news can trigger a large number of aggressive, but ill-informed buy or sell orders, or a large trade may suck out liquidity - the availability of shares to buy or sell. Both events can unsettle market makers and lead them to step away.

Normally, such a move would cause the stock to be halted, but the rules don't apply to the first 15 minutes or last 25 minutes of the day. That will change in August when the second-phase of the upgraded program for trading halts rolls out.

A week after the Anadarko mishap, shares of utilities American Electric Power Inc and NextEra Energy Inc fell more than 50 percent in the first minute of trading. The shares immediately rebounded, but the out-of-sync prices were allowed to stand.

However, these may be becoming rarer exceptions.

One sign of a more stable market is the reduced number of times an exchange is in distress and orders must be routed elsewhere, said the Financial Information Forum, which brings together exchanges, brokers, and others to examine issues related to the life of an order from inception to final payment.

For example, the amount of time Nasdaq has declared another exchange is having difficulties dropped to about 12 hours in 2012 from 120 hours in 2007, when new regulation ushered in a fully electronic market, FIF data shows.

And while trading in individual securities was halted an average of 63 times a month from August 2011 - the month that the program was expanded to all securities - through December 2011, that monthly average has dropped to only 23 since the beginning of 2012.

Credit Suisse, which operates an alternative trading system called CrossFinder, estimated that of the 550 such halts it has tracked from June 2010 to December 2012, just 21 were undeniably disruptive. They accounted for 0.0000001 percent of the approximately 17.5 billion trades executed in that period.

Many of the halts were in low-priced illiquid stocks that trade infrequently, and another 40 percent came after company-specific news caused a dramatic reaction in a stock.

Still, some industry experts said they are still not convinced that there is enough transparency on the issue.

They said it would boost investor confidence if FINRA, the SEC and the exchanges were to more widely publish data on the number of erroneous trades and why they have occurred. FINRA's Ketchum said he is prepared to consider this.

"When we hear nothing, see nothing, we naturally assume nothing's being done," said James Angel, a professor at Georgetown University who specializes in financial market regulation and structure.

(Reporting by Herbert Lash; Editing by Martin Howell and Leslie Gevirtz)