Making sure the market isn't being gamed

It looks like Finra isn't waiting for the Securities and Exchange Commission to figure out how high-frequency traders are affecting the market. Last week, it fined Trillium Brokerage Services LLC $1 million for placing large volumes of equity orders with the intention of later canceling them, apparently for the purpose of misleading computerized-trading systems, such as those used by high-frequency traders. The Financial Industry Regulatory Authority Inc. is to be applauded for its action, and it must continue to scrutinize the trading patterns of other firms to determine if they also have been playing this game, and if such actions have led to serious market distortions such as the May 6 flash crash. Finra's actions, combined with the examination of high-frequency trading by the SEC, should help restore the credibility of the equity markets with individual investors, who have been fleeing in large numbers. In July, for example, U.S. investors withdrew $11.12 billion from equity mutual funds that invest primarily in the United States — on top of the $7.52 billion that they withdrew in June. From January 2008 through July, investors pulled a net $244 billion out of stock mutual funds. On Sept. 7, SEC Chairman Mary Schapiro told The Economic Club of New York about retail brokers who have told the commission that their customers have pulled back from equities. “Every single week since May 6 has seen an outflow of funds from equity mutual funds,” she said. Some of the equity pullback no doubt is a result of the stock market's poor delivery over the past 10 years — certainly not enough to reward investors for the risk taken. But withdrawals have accelerated since May, suggesting that investors have come to believe that the market is being gamed by high-frequency traders, short sellers, hedge funds and other Wall Street professionals. Academics may argue that high-frequency traders and short sellers increase market liquidity and reduce trading costs. Individual investors don't appear to buy that argument and are unlikely to return to equities in large numbers until they are reassured that the market is fair. Like Finra, the SEC is probing the activities of many trading firms that flood the market with orders in order to test quotes, and it is investigating whether procedures at firms that cancel high percentages of their orders involve fraud. The SEC has taken some preliminary steps to re-establish confidence. It instituted circuit breakers that halt trading temporarily in stocks in which prices move 10% or more within five minutes. And it is considering other steps to improve the circuit breaker mechanism. But before taking additional steps, the SEC must investigate the causes of the flash crash, identify the weaknesses in market regulations that allowed it to happen and then prescribe the appropriate treatment. And it must publish its findings and proposed solutions in a timely fashion. It must not follow the pattern of the financial-reform law passed this year — where solutions were imposed before the causes were diagnosed by the Financial Crisis Investigation Committee. There should also be vigorous open debate before final rules are published. Only then will the public believe that regulators have correctly identified the causes and devised the correct solutions. Only when individual investors are satisfied that the deck isn't stacked against them will they return to the equity market.