When markets opening in New York City this morning, shares of American Electric Power and Nextera Energy, two big electric utilities trading on the NYSE, took a complete nosedive.
American Power briefly plunged 54%, and Nextera Energy plunged 62% — the question is why.
To figure out what caused this crash, Business Insider reached out to Eric Hunsader, founder of Nanex, a research firm that compiles and analyses market data.
First thing’s first, it’s important to realise that this morning was the morning after a Fed announcement. Hunsader said that since utility stocks are impacted by moves in interest rates, it’s likely that traders were repositioning themselves based on Bernanke’s comments.
The problem is that as they were all rushing to sell, there weren’t enough buyers.
“It just so happened that this morning there was no liquidity and that sector just got killed,” said Hunsader.
Now the question, then, is why hasn’t this happened before?
The explanation for that lies in regulation. The NYSE used to use a measure called the Liquidity Replenishment Point (LRP) to stop crashes like this. Basically, when an order goes in and removes a lot of liquidity in stock, the NYSE slows down trading so liquidity can trickle back in.
However, after the 2010 flash crash, regulators decided to make the NYSE dump LRPs and put them in line with the crash preventing measures other exchanges were using. NYSE objected, saying their way was better for investors, but they lost out on that one.
In place of LRP, and as a pilot for one year, NYSE adopted the Limit-Up Limit-Down (LULD) system last month.
With LULD, essentially, trading in a stock will halt for five minutes if the price of a stock suddenly moves up or down 5%-10% compared to the average price for the last five minutes. It’s 5% for S&P and large cap stocks, 10% for small stocks.
Ideally, price bands should double at the open and the close, since volatility is more likely.
The problem is that, until August, LULD isn’t going to be implemented for the first 15 minutes of the trading day, and the last 30 minutes of the trading day at all.
And that’s just one thing according to Hunsader. The real problem, he said, is that creating price bands isn’t enough. It’s too confusing, and liquidity is gone faster than people think.
“It’s not going to take care of 99% of what we [Nanex] see,” he said.
And what Nanex sees are 2-3% drops in stocks all the time — mini flash crashes that pop stocks (even large cap stocks) up and down with little explanation. Usually, the market just keeps on moving, but that may not always be the case. It wasn’t during the Flash Crash — which is exactly the scenario that regulators are trying to prevent.
“It’s going to be a nightmare when we have a big market move and a lot of stocks trip, because no one will know when to stop them,” he continued. “We would like to know if the SEC tested this LULD regulation on Flash Crash data.”
That would be a good thing to know indeed.