Assignment

The Regulatory Origins of the Flash Crash9

On May 6, 2010, the stock market suddenly swung a thousand points. Nobody really knows why. But Dennis Berman, in the Wall Street Journal, has a clue: Maybe the regulators did it. He notes that it results from 1975 market reforms aimed at eliminating market makers who were increasing trading costs by increasing spreads:

By the time the last big market reforms were issued in 2005, the intent was to "give investors, particularly retail investors, greater confidence that they will be treated fairly," the SEC said at the time.

But now those greedy market makers have been replaced by machines, leaving nobody with the responsibility to step in at a time of distress like the flash crash. So according to Berman, we have traded cheaper up-front costs for unknown back-end ones. That is exactly what is spooking the same investors the SEC vowed to protect in 2005.

Congress is now thinking of fixing this system, apparently suggesting that maybe investors are not, in the words of Delaware's Senator Kaufman, "best served by narrow spreads." And we'll undoubtedly get a regulatory fix, perhaps in the form of the Dodd-Frank bill enacted in 2010. But will additional regulations solve matters? Berman quotes Vanderbilt's William Christie: "It's kind of like a balloon-you squish one side, and it pops out the other."

Exercises

1. Could it be possible that a government regulation led to the flash crash? Explain.

2. What does it mean "it's like a balloon"? What is like a balloon? Why is it like a balloon?

3. Explain why government regulations to restrict some activity occurring in a free market typically end up making matters worse.

4. Who supported the Dodd-Frank bill? Who opposed it?