Stock 'circuit breakers' could avoid flash crash

Implementing a new circuit breaker to halt trading following sudden drops could avoid the type of white-knuckle crash that equity investors saw during May's flash crash, a financial industry watchdog said Thursday.

The Investment Industry Regulatory Organization of Canada (IIROC) examined 47 Canadian stocks that saw heavy losses on May 6, a day known in financial circles as the "flash crash" because North American equity markets lost billions of dollars in value in a matter of minutes that afternoon, seemingly without cause.

The TSX lost nearly 500 points that day before coming back later in the session.

An IIROC report on the crash released Thursday found that no single factor was a cause across all major decliners — suggesting a myriad of issues caused the overall drop.

"While a number of factors were identified that affected trading, no one factor was common to the trading in all of the 47 securities reviewed," the report said.

Although there were rumours of nefarious rogue traders or some sort of cataclysmic human error, a simple influx of sell orders and the snowball effect of thousands of stop-loss orders being triggered as prices declined appears to have caused the contagion, the report found.

After U.S. stock prices declined rapidly, electronic traders withdrew from the market which further reduced liquidity and spurred more losses, the report said.

"The review found no evidence of erroneous orders, computer glitches or any futures or options trading that spurred the decline in the Canadian marketplaces," the report said.

In general Canadian stocks followed U.S. activity, with the onset of the decline and beginning of the recovery lagging behind U.S. markets by roughly two minutes.

Among the report's recommendations was the suggestion that stock markets review the current market-wide circuit breaker to determine if the current trigger levels are appropriate.

"Circuit breakers work to an extent," said Conor Bill, managing director at Mt. Auburn Capital, in Toronto, in reaction to the report.

"They're a crude mechanism for stopping plunges, and they are good at that, [but] they may need some adjustments in terms of the numbers at which they kick in."

Many stock exchanges currently have systems in place to halt trading after the market has lost or gained a certain percentage during a set amount of time. But none were triggered that day.

"The circuit breakers work as well as they are expected to," Bill said. "Nothing can be expected to eliminate gross human error."

The report also recommended the possibility of Canada adopting its own, Canadian-based circuit breaker, so that Canadian equity markets are not dragged down by crashes elsewhere.

The report is merely a series of recommendations, and the agency says it will work with the industry to discuss the possibility of implementing changes down the line.