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By Paul Justice, CFA | 07-09-2010 11:49 AM

Vanguard's Sauter on How to Prevent Another Flash Crash

Vanguard's Chief Investment Officer Gus Sauter outlines his ideas for robust market circuit breakers and other trading changes.

Paul Justice: Hi there. I'm Paul Justice, Director of ETF Research in North America for Morningstar. Today I'm here to discuss the regulatory reforms following the flash crash of May 6th and 22 minutes of infamy. I'm joined by a central figure in the discussions Gus Sauter, Chief Investment Officer of Vanguard.

Gus, thank you for joining me.

Gus Sauter: Thank you, Paul for having me.

Justice: Now, while the cause of the flash remain unknown right now, it seems like we've really identified that we have some market structure problems that regulators are addressing and you've had several inputs as to some of the directions that should be chosen. Could you go over some of the most recent rulings? First of all, we'll discuss some of the circuit breakers that are discussed right now to help prevent future crashes from happening and how you think that these are going to perform and what other things need to be implemented?

Sauter: Sure. Yeah. So the SEC has implemented a pilot program with circuit breakers and any time a stock declines 10% in a five minute period, basically a halt is called, everybody has to take a time out and wait for five minutes before trading resumes. I do think that that's a good concept. I will admit that years ago when we started introducing circuit breakers at the market level that I wasn't really a fan of it, but I have changed my thinking over the years.

And the real reason is, because I recognize that at times people get a little hysterical overall, subject to perhaps panicking in times of duress, and when that happens we need to step back and ask ourselves is something really different or are we overreacting here. And so I think having this circuit breaker and stopping things for a few minutes, giving us time to reassess the situation actually will be a benefit and we'll see how that works out in the pilot program.

Justice: Sure. Now, speaking of kind of panicking and pulling out of the market, one of the participants that we saw in this were the market makers as we call them and often times these are the high-frequency traders that really enable the ETF marketplace to exist. Could you discuss their role in the marketplace and what reforms may be coming that could impact the market makers themselves?

Sauter: Yeah. So there are really are three different types of markets makers, if you will. There is a specialist in some cases where there is somebody who is a designated market maker required to make markets. There is also electronic market makers, who are designated as market makers on various exchanges where ETFs may trade, and then there are these high-frequency traders that you're referencing and these traders are making markets when they feel like making markets and perhaps disappearing at other points in time, but all of these are helping to provide liquidity to the marketplace.

What we saw was that they tended to disappear from this on May 6, but I would point out it wasn't just the high-frequency traders who decided not to make markets, it was the other market makers as well, who might be designated as market makers who had stepped back, and even on exchange traded products like stocks these specialist stepped back away as well. So, it's not just high-frequency traders that perhaps abandoned us, if you will, on that day.

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