We must cure what ails our financial markets

Our historically free, fair and credible markets are in danger. Investors from all over the world once came here to invest because they believed in our markets’ transparency and fairness. We are losing some of those investors, as well as individual investors here at home, at an alarming rate.

Many who stayed through the bursting of the dotcom bubble only to be hit by the great financial meltdown and now by record recent volatility, have changed their minds about how fair our markets are.

For decades, U.S. markets have been dominant. With the advent of new technologies and regulatory improvements in the markets of other countries, however, investors are deciding they have other choices of where to buy and sell.

In the past two weeks, U.S. stock markets experienced record daily volume and volatile up and down swings. A News Journal article on Aug. 14 quoted Bloomberg News, which said that the volume of equities traded from Aug. 4 through Aug. 10 set a record for any five-day period, and attributed the increased volatility to High Frequency Trading.

HFT got its start back in 2001, when the SEC ruled that stock prices, instead of rising or falling by a sixteenth of a point as they had in the past, would henceforth be denominated in pennies – 1/100 of a point.

Over the next few years, greatly aided by advances in computer technology, HFT took off.

Very sophisticated traders can now use computer algorithms, not human beings, to execute thousands of trades in less than a second. In fact, well over 50 percent of all trades in our markets are now done using HFT. This isn’t your father’s stock market any more.

Trying to get our regulators, the SEC and the Commodities Future Trading Commission to rein in high frequency trading was one of my highest priorities when I was in the Senate.

Because of HFT’s speed and complexity, and the growth of unregulated markets, the SEC and CFTC really know very little about its effects on markets. The lack of meaningful oversight of HFT is a frightening parallel, I think, to what happened with derivatives during the financial meltdown of 2008.

I asked for a number of safeguards, such as monitoring conflicts of interest to assure that retail investors were being treated fairly. I also asked for a consolidated audit trail that would make it easier for regulators to investigate unusual trading activity across securities markets.

Had we had such an audit trail, we might have avoided the “flash crash” on May 6, 2009, when the market fell 900 points in minutes.

It took the commission five months to come out with a report on that event, and the report itself left many important questions unanswered.

The other cause of volatility, especially when it involves large stock declines, is abusive short selling.

Short selling is the practice of selling a security you do not own, hoping it will decline in price so you can deliver it at a lower price and make a profit.

Short selling has been in use since the inauguration of markets and has a positive role to play. But, until 2007, a trader could sell a stock short only on an uptick in its price.

Unwisely, that year the SEC discarded the uptick rule.

It also watered down a rule that said that if you did not own the stock you sold, you had to borrow an equivalent amount. When Bear Stearns and Lehman Brothers started to crumble in 2006, many believed manipulative “naked” short sellers (traders who sold short without any borrowed stock) helped drive both firms into the ground.

When I was in the Senate, I led a bipartisan group that called on the SEC to reinstate the uptick rule and banish naked short selling.

To date, the agency has done nothing to reinstate the old rules. The regulators are also years away from establishing a consolidated audit trail.

Before it is too late, before we lose our position as the world’s leading financial center, we must restore confidence in our markets.

The only way to do that is to reinstitute time-tested rules on short selling and make certain that new technologies and trading mechanisms are understood, properly regulated, and working for the benefit of all investors.

Originally published 21 Aug 2011 on delawareonline.com