“In summary, our analysis of trades broken on May 6 reveals they were concentrated primarily among a few market participants. A significant number of those trades were driven by sell orders from retail customers sent to internalizers for immediate execution at then-current market prices,” the US Commodity Futures Trading Commission and the US Securities and Exchange Commission concludes in their just released report on the so-called “flash crash” on May 6th this year. And they seem to have found a scapegoat:
“At 2:32 p.m., against this backdrop of unusually high volatility and thinning liquidity, a large fundamental trader 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.”
US Commodity Futures Trading Commission – US Securities and Exchange Commission
“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. The execution of this sell program resulted in the largest net change in daily position of any trader in the E-Mini since the beginning of the year,” the report says.
The “large fundamental trader” have been identified as the 73 years old investment firm Waddell & Reed.
“Only two single-day sell programs of equal or larger size – one of which was by the same large fundamental trader – were executed in the E-Mini in the 12 months prior to May 6. When executing the previous sell program, this large fundamental trader utilized a combination of manual trading entered over the course of a day and several automated execution algorithms which took into account price, time, and volume. On that occasion it took more than 5 hours for this large trader to execute the first 75,000 contracts of a large sell program,” SEC and CFTC notes.
Adding: “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. “
According to the report, the sell pressure was initially absorbed by:
1. High frequency traders (“HFTs”) and other intermediaries8 in the futures market;
2. Fundamental buyers in the futures market; and
3. Cross-market arbitrageurs9 who transferred this sell pressure to the equities markets by opportunistically buying E-Mini contracts and simultaneously selling products like SPY, or selling individual equities in the S&P 500 Index.
“HFTs and intermediaries were the likely buyers of the initial batch of orders submitted by the Sell Algorithm, and, as a result, these buyers built up temporary long positions. Specifically, HFTs accumulated a net long position of about 3,300 contracts. However, between 2:41 p.m. and 2:44 p.m., HFTs aggressively sold about 2,000 E-Mini contracts in order to reduce their temporary long positions. At the same time, HFTs traded nearly 140,000 E-Mini contracts or over 33% of the total trading volume. This is consistent with the HFTs’ typical practice of trading a very large number of contracts, but not accumulating an aggregate inventory beyond three to four thousand contracts in either direction.”
“The Sell Algorithm used by the large trader responded to the increased volume by increasing the rate at which it was feeding the orders into the market, even though orders that it already sent to the market were arguably not yet fully absorbed by fundamental buyers or cross-market arbitrageurs. In fact, especially in times of significant volatility, high trading volume is not necessarily a reliable indicator of market liquidity.”
What happened next is best described in terms of two liquidity crises, the report says.
A Double Squeeze
“The combined selling pressure from the Sell Algorithm, HFTs and other traders drove the price of the E-Mini down approximately 3% in just four minutes from the beginning of 2:41 p.m. through the end of 2:44 p.m. During this same time cross-market arbitrageurs who did buy the E-Mini, simultaneously sold equivalent amounts in the equities markets, driving the price of SPY also down approximately 3%,” the regulators write.
“Still lacking sufficient demand from fundamental buyers or cross-market arbitrageurs, HFTs began to quickly buy and then resell contracts to each other – generating a “hot-potato” volume effect as the same positions were rapidly passed back and forth. Between 2:45:13 and 2:45:27, HFTs traded over 27,000 contracts, which accounted for about 49 percent of the total trading volume, while buying only about 200 additional contracts net.”
At this time, buy-side market depth in the E-Mini fell to about $58 million, less than 1% of its depth from that morning’s level. As liquidity vanished, the price of the E-Mini dropped by an additional 1.7% in just these 15 seconds, to reach its intraday low of 1056.
“This sudden decline in both price and liquidity may be symptomatic of the notion that prices were moving so fast, fundamental buyers and cross-market arbitrageurs were either unable or unwilling to supply enough buy-side liquidity,” the report explains.
In the four-and-one-half minutes from 2:41 p.m. through 2:45:27 p.m., prices of the E-Mini had fallen by more than 5% and prices of SPY suffered a decline of over 6%.
“The second liquidity crisis occurred in the equities markets at about 2:45 p.m. Based on interviews with a variety of large market participants, automated trading systems used by many liquidity providers temporarily paused in reaction to the sudden price declines observed during the first liquidity crisis. These built-in pauses are designed to prevent automated systems from trading when prices move beyond pre-defined thresholds in order to allow traders and risk managers to fully assess market conditions before trading is resumed,” the report says.
Okay, before I continue, let’s relive the historical – and totally crazy – 20 minutes on the afternoon of May 6th. (Cut down to 10) as the old saying that “pictures are best on radio” once again proves its infinity:
A Triple Dose
According to the US regulators, there’s also three important lessons to be learned from the May 6th event.
#1. “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. As the events of May 6 demonstrate, especially in times of significant volatility, high trading volume is not necessarily a reliable indicator of market liquidity.”
#2. “May 6 was also an important reminder of the inter-connectedness of our derivatives and securities markets, particularly with respect to index products. The nature of the cross-market trading activity described above was confirmed by extensive interviews with market participants (discussed more fully herein), many of whom are active in both the futures and cash markets in the ordinary course, particularly with respect to “price discovery” products such as the E-Mini and SPY.”
#3. “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.”
The regulators have conducted a series of interviews with market participants involved in the May 6th flash crash.
According to the interviews, almost everyone says they use a combination of automated algorithms and human traders to oversee their operations.
As such, data integrity was cited by the firms we interviewed as their number one concern, the report points out.
“To protect against trading on erroneous data, firms implement automated stops that are triggered when the data received appears questionable.”
“One way of identifying potentially erroneous data is to screen for large, rapid price moves. For example, it was reported that the rapid decline in prices of the E-Mini, starting around 2:40 p.m. triggered data-integrity pauses in trading across a number of automated algorithms. Rapid declines in individual securities also contributed to data-integrity concerns and triggered trading pauses. Collectively we refer to these as “price-driven integrity pauses.”
“It is important to note these types of pauses are not necessarily the result of erroneous price data, but instead are based on prudential checks into the possibility that large, observed price changes are the by-product of a system error. In fact, the large price declines simultaneously observed across securities and the E-Mini contract during the afternoon of May 6 were indeed real.”
Very High – Very Low
The high frequency trading have been suspected as a possible cause of the flash crash.
However, the SEC/CFCT report can’t confirm or dismiss the accusations.
“Of the HFTs we interviewed, we did not find uniformity in response to market conditions on May 6. Although some HFTs exited the market for reasons similar to other market participants, such as the triggering of their internal risk parameters due to rapid price moves and subsequent data-integrity concerns, other HFTs continued to trade actively. Among those HFTs that continued to trade, motivations varied, but were in part based on whether they thought their algorithms would be able to operate successfully (profitably) under the extreme market conditions observed that afternoon.”
“In summary, our analysis of trades broken on May 6 reveals they were concentrated primarily among a few market participants. A significant number of those trades were driven by sell orders from retail customers sent to internalizers for immediate execution at then-current market prices. Internalizers, in turn, routed these orders to the public exchanges for execution at the NBBO. However, for those securities in which market makers had withdrawn their liquidity, there was insufficient buy interest, and many trades were executed at very low (and sometimes very high) prices, including stub quotes.”
I guess the econotwisted way to sum this up will be:
On May 5th 2010 all the money in the US stock market disappeared for some reason – and after about 20 minutes they suddenly came back, for some reason….
Select Your Language:
- Positive Feedback and the Flash Crash (wallstreetpit.com)
- Flash Crash Report: The Unnamed ‘Large Fundamental Trader’ (blogs.wsj.com)
- Here’s How The SEC Blames This Guy For Flash Crash Without Actually Blaming Him (businessinsider.com)
- Dissecting The Flash Crash (blogs.forbes.com)
- One trader behind flash crash (financialpost.com)
- UPDATE 4-Single U.S. trade helped spark May’s flash crash (reuters.com)