A report by US financial regulators has identified the attempt to sell 75,000 index futures contracts by a “mutual fund complex” using an execution algorithm in extremely volatile market conditions as the trigger for market mayhem on 6 May.
According to a joint report released on Friday, 1 October by the Securities and Exchanges Commission (SEC) and the Commodity Futures Trading Commission (CFTC) on 6 May's ”flash crash' – which temporarily saw sharp declines of up to 15% in the price of indices and individual instruments – the inability of the market to absorb such a large order was the cause of the rapid downward spiral in values.
The execution algorithm was programmed by the mutual fund complex to feed orders into the June 2010 E-Mini S&P 500 futures market, targeting an execution rate of 9% of “trading volume calculated over the previous minute, but without regard to time or price”.
The mutual fund had initiated a similar-sized sell program once before in the preceding 12 months – but with the algorithm configured to take account of price, time and volume, and supported by some manual trading – on which occasion the first 75,000 contracts of the program took five hours to execute.
On 6 May however, such was the level of volatility and activity in the market that the mutual fund sold roughly 35,000 E-Mini contracts in less than 14 minutes.
Since 6 May, the SEC has introduced new rules on exchange circuit breakers and announced plans for stricter reporting requirements for high-volume traders. The circuit breakers halt trading on all US trading venues for five minutes across all stocks in the Russell 1000 index and selected exchange-traded funds, should prices deviate by 10% in the preceding five-minute period. The circuit breaker programme is in pilot until 10 December. The large trader reporting system proposes the creation of a single audit trail of data and other reporting obligations for high volume traders. Following uncertainty from market participants on 6 May about the process for breaking trades, the Financial Industry Regulation Authority (FINRA) has worked with the SEC and exchanges to “clarify the process for breaking erroneous trades using more objective standards”.
Adam Sussman, director of research at research consultancy TABB Group, said, “There is nothing in the report that suggest if the SEC had the consolidated audit trail that they could have done something to minimize the events of the day. But maybe the report could have been done in a few weeks rather than five months. I am not sure that's worth US$4 billion.”
In the latest report, the SEC said that staff would evaluate the operation of the circuit breaker programme and the new procedures for breaking trades. It also stressed the importance of the accessibility, timeliness and accuracy of market data.
“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,” the report said. “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.”
The SEC-CFTC report into the cause of the flash crash establishes the following timeline in the US securities and derivatives markets on 6 May:
Morning session: US markets open to increased concerns over the European debt crisis and the implications of a potential debt default by the Greek government.
13.00 – Falls in the value of the euro against the US dollar and the Japanese yen begin to increase price volatility in a number of individual securities. The New York Stock Exchange experiences high-than-average triggering of Liquidity Replenishment Points, i.e. pauses in trading to boost liquidity caused by volatility.
14.30 – Selling pressure has forced the Dow Jones Industrial Average down by 2.5% and liquidity in the two most actively traded stock index instruments – the E-Mini and the S&P 500 exchange-traded fund (SPY) – had fallen by 55% and 20% respectively.
14.32 – Against a background of unusually high volatility and diminishing liquidity, the mutual fund complex initiates the sale of 75,000 E-Mini contracts via an execution algorithm as a hedge to an existing equity position.
14.41-14.44 – High-frequency traders (HFTs) that have absorbed the mutual fund's bulk order aggressively sell their long E-Mini positions in line with their practice of not accumulating significant inventory in any individual instrument. HFTs account for 33% of trading volume in E-Mini contracts at this time. Despite the fact that its initial orders are not fully absorbed by the market, the mutual fund's algorithm increases the rate at which it is feeding orders into the market in response to the increased volume. The price of the E-Mini falls 3% and cross-market arbitrageurs that buy the contract while selling equivalent amounts in the equities market contribute to a similar fall in the price of the SPY.
14.45 – Because other market participants have withdrawn on account of extreme price volatility, HFTs have little choice but to pass the E-Mini contracts between themselves. “Between 14.45:13 and 14.45:27, HFTs traded over 27,000 contracts, which accounted for about 49% of the total trading volume, while buying only about 200 additional contracts net,” the report noted, adding that buy-side market depth was less than 1% of that recorded in the morning session. The E-Mini reached its intraday low of 1056. At 14.45:28 the CME derivatives exchange paused trading in the E-Mini for five seconds to alleviate selling pressure causing prices to stabilise and eventually recover. The mutual fund's algorithm continues to sell until 14.51 as prices continue to rise.
Meanwhile in the equities market, market participants reacted to market conditions by pausing their automated trading systems, with some market makers widening their spreads, reducing available liquidity or withdrawing from trading activity entirely. HFT activity increased as a proportion of trading volume, with such firms overall net sellers.
Prices in individual stocks continued to decline despite the recovery in the value of the E-Mini and SPY due to the withdrawal of so many market participants. The absence of available buy interest meant that many trades were executed as low as one penny or as high as US$100,000 as orders gravitated toward stub quotes generated by market makers to fulfil two-sided quoting obligations.
15.00 – Most securities had reverted back to consensus values, but in the prior 20 minutes more than 20,000 trades across 300-plus securities were executed at prices more than 60% away from their 14.40 levels. After the market closed, exchanges met with FINRA to agree to cancel “clearly erroneous” trades.