The SEC and CFTC issued their report on the flash crash of May 6th today arguing that a single large investor, previously identified as Waddell & Reed Financial, entered a computerized selling order that caused a cascade of selling across the market. The report provides a good synopsis of what happened. Below are the notable excerpts from the report:Summary
On May 6, 2010, the prices of many U.S.-based equity products experienced an extraordinarily rapid decline and recovery. That afternoon, major equity indices in both the futures and securities markets, each already down over 4% from their prior-day close, suddenly plummeted a further 5-6% in a matter of minutes before rebounding almost as quickly...
...Over 20,000 trades across more than 300 securities were executed at prices more than 60% away from their values just moments before. Moreover, many of these trades were executed at prices of a penny or less, or as high as $100,000, before prices of those securities returned to their “pre-crash” levels.
What happened in e-minis?
At 2:32 p.m., against this backdrop of unusually high volatility and thinning liquidity, a large fundamental trader (a mutual fund complex) initiated a sell program to sell a total of 75,000 E-Mini contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position...
...This large fundamental trader chose to execute this sell program via an automated execution algorithm (“Sell Algorithm”) that was programmed to feed orders into the June 2010 E-Mini market to target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time...
...However, on May 6, when markets were already under stress, the Sell Algorithm chosen by the large trader to only target trading volume, and neither price nor time, executed the sell program extremely rapidly in just 20 minutes...
...Between 2:32 p.m. and 2:45 p.m., as prices of the E-Mini rapidly declined, the Sell Algorithm sold about 35,000 E-Mini contracts (valued at approximately $1.9 billion) of the 75,000 intended. During the same time, all fundamental sellers combined sold more than 80,000 contracts net, while all fundamental buyers bought only about 50,000 contracts net, for a net fundamental imbalance of 30,000 contracts. This level of net selling by fundamental sellers is about 15 times larger compared to the same 13-minute interval during the previous three days, while this level of net buying by the fundamental buyers is about 10 times larger compared to the same time period during the previous three days.
What happened in equities?
Based on their respective individual risk assessments, some market makers and other liquidity providers widened their quote spreads, others reduced offered liquidity, and a significant number withdrew completely from the markets. Some fell back to manual trading but had to limit their focus to only a subset of securities as they were not able to keep up with the nearly ten-fold increase in volume that occurred as prices in many securities rapidly declined...
...HFTs in the equity markets, who normally both provide and take liquidity as part of their strategies, traded proportionally more as volume increased, and overall were net sellers in the rapidly declining broad market along with most other participants. Some of these firms continued to trade as the broad indices began to recover and individual securities started to experience severe price dislocations, whereas others reduced or halted trading completely...
...Between 2:40 p.m. and 3:00 p.m., approximately 2 billion shares traded with a total volume exceeding $56 billion. Over 98% of all shares were executed at prices within 10% of their 2:40 p.m. value. However, as liquidity completely evaporated in a number of individual securities and ETFs,11 participants instructed to sell (or buy) at the market found no immediately available buy interest (or sell interest) resulting in trades being executed at irrational prices as low as one penny or as high as $100,000. These trades occurred as a result of so-called stub quotes, which are quotes generated by market makers (or the exchanges on their behalf) at levels far away from the current market in order to fulfill continuous two-sided quoting obligations even when a market maker has withdrawn from active trading.
Lessons Learned
One key lesson is that under stressed market conditions, the automated execution of a large sell order can trigger extreme price movements, especially if the automated execution algorithm does not take prices into account. Moreover, the interaction between automated execution programs and algorithmic trading strategies can quickly erode liquidity and result in disorderly markets...
...May 6 was also an important reminder of the inter-connectedness of our derivatives and securities markets, particularly with respect to index products...
...Another key lesson from May 6 is that many market participants employ their own versions of a trading pause – either generally or in particular products – based on different combinations of market signals. While the withdrawal of a single participant may not significantly impact the entire market, a liquidity crisis can develop if many market participants withdraw at the same time. This, in turn, can lead to the breakdown of a fair and orderly price-discovery process, and in the extreme case trades can be executed at stub-quotes used by market makers to fulfill their continuous two-sided quoting obligations...
...A further observation from May 6 is that market participants’ uncertainty about when trades will be broken can affect their trading strategies and willingness to provide liquidity. In fact, in our interviews many participants expressed concern that, on May 6, the exchanges and FINRA only broke trades that were more than 60% away from the applicable reference price, and did so using a process that was not transparent...
...Whether trading decisions are based on human judgment or a computer algorithm, and whether trades occur once a minute or thousands of times each second, fair and orderly markets require that the standard for robust, accessible, and timely market data be set quite high. Although we do not believe significant market data delays were the primary factor in causing the events of May 6, our analyses of that day reveal the extent to which the actions of market participants can be influenced by uncertainty about, or delays in, market data.
Accordingly, another area of focus going forward should be on the integrity and reliability of market centers’ data processes, especially those that involve the publication of trades and quotes to the consolidated market data feeds. In addition, we will be working with the market centers in exploring their members’ trading practices to identify any unintentional or potentially abusive or manipulative conduct that may cause system delays that inhibit the ability of market participants to engage in a fair and orderly process of price discovery.
Download the full report here.