Single Trader Caused 'Flash Crash'

by Glen Shapiro, LawAndTax-News.com, New York

06 October 2010

The United States Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) have released a joint report presenting their findings regarding the stock market disruption seen on May 6 this year.

The 'Flash Crash,' as it is called, was an extreme movement in the prices of many US-based equity products that experienced an extraordinarily rapid decline and recovery. For example, it was the biggest point decline on an intraday basis, almost 1,000 points, in the Dow Jones Industrial Average’s history.

While trading in the US markets on May 6 opened to unsettling political and economic news from overseas concerning the European debt crisis, 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.

However, some equities experienced even more severe price moves, both up and down. 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 USD100,000, before prices of those securities returned to their “pre-crash” levels.

The report identifies the original source of the crash as “a large fundamental trader”, who remains unnamed but who is defined as “a multi-fund complex”. That trader, against the general backdrop of unusually high volatility and thinning liquidity, initiated a programme to sell a total of 75,000 contracts, valued at approximately USD4.1bn, as a hedge to an existing equity position.

Above all, however, the trader chose to execute the programme via an automated algorithm, targeting an execution rate set to market trading volume, but without regard to price or time. As a result, with markets already under stress, the sell algorithm completed the sell program extremely rapidly in just 20 minutes. This, together with the reaction of other traders’ super-fast trading programmes to their consequent long positions, sent indices plummeting.

As the report points out, one key lesson is that “the interaction between automated execution programmes 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,” the report noted.

The SEC is therefore already considering whether high frequency traders, who are effectively market makers in present-day markets, should be subject to more meaningful obligations to promote fair and orderly markets. The regulator also continues to work with the exchanges to prohibit the use by market makers of "stub" quotes that are not intended to indicate actual trading interest; and is studying the impact of multiple trading protocols at the exchanges.

Another key lesson from May 6 brought out by the report is that many market participants employ their own versions of a trading pause 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,” the report observes.

In response to this phenomenon, and to curtail the possibility that a similar liquidity crisis can result in circumstances of such extreme price volatility, the SEC and FINRA have already implemented a circuit breaker pilot programme for trading in individual securities. Trading in a security included in the programme is now paused for a five-minute period if the security experiences a 10% price change over the preceding five minutes.

A further observation made in the study concerns market participants’ uncertainty about when trades will be broken, a factor that can affect their trading strategies and willingness to provide liquidity. To provide market participants more certainty as to which trades will be broken and allow them to better manage their risks, the SEC and FINRA have approved new trade break procedures which, like the circuit breaker programme, are in effect on a pilot basis until December 10, 2010.

Going forward, the SEC is to evaluate the operation of the circuit breaker programme and the new procedures for breaking erroneous trades during the pilot period, particularly to assess whether the current circuit breaker approach could be improved by adopting or incorporating other mechanisms.

In connection with the report, SEC Chairman, Mary L. Schapiro, and CFTC Chairman, Gary Gensler, emphasize that: "This report identifies what happened and reaffirms the importance of a number of the actions we have taken since that day. We now must consider what other investor-focused measures are needed to ensure that our markets are fair, efficient and resilient, now and for years to come."

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