The US regulators' report on the ”flash crash' of 6 May placed heavy emphasis on the trigger effect of a single trade. What the crash really demonstrated was that a market built from ill-fitting parts risks collapse under pressure. “We have this Frankenstein market, which is a fragmented mess of exchanges and dark pools – that's the real issue here,” said Joseph Saluzzi, co-head of the trading desk at agency broker Themis Trading.
A mutual fund sell order of 75,000 index futures contracts was put squarely in the frame in the report issued jointly by US regulatory authorities the Securities and Exchanges Commission (SEC) and the Commodity Futures Trading Commission (CFTC) on 4 October. The order was managed by an algorithm using just one parameter – 9% of market volume – in contrast with a previous similar order that included price and time parameters.
Saluzzi points out that the SEC-CFTC report highlighted a number of other contributing factors to unusually high levels of volatility on 6 May, including flow that would typically have been internalised.
“There's nothing intrinsically wrong with a 9% participation rate order,” said Saluzzi. “There are bigger villains. What about a market maker that takes a retail order, which it normally does by internalising most of it, then instead deciding to send it out to the market? They are partially to blame too. That volume doesn't normally get to the market and it created more stress in the system.”
During the crash, which lasted from 14.40 to 15.00, the market fell by almost 1,000 points before recovering. High trading volumes on that day were not an accurate indicator of market liquidity, as a lot of volume was driven by high-frequency trading firms (HFT), trading on assets rather than holding them. At one point, HFT firms traded 27,000 contracts in 14 seconds, accounting for 49% of volume in the E-Mini S&P 500 futures market, while only buying 200 contracts net.
Kevin Cronin, global head of equity trading at asset management firm Invesco, acknowledges that with hindsight the sell order looks like a bad strategy but its responsibility ends there. “It did not create the friction in the market, or the multitude of poorly connected exchanges with different rules, or necessarily the retreat of market participants who are ordinarily there making markets,” he observed.
As market makers shrank away from the volatile market conditions, the scale of the withdrawal saw prices spiralling downward, with sell orders finding no buyers until they reached stub quotes left in place to fulfil market-making obligations. These trades led to the stocks of blue-chip firms trading at prices as low as $0.01 cent for a brief period, before recovering. Trades that executed at 60% off the best bid offer price during this period were later broken by exchanges, a decision that has been met with annoyance by trading firms that feel the break point was decided arbitrarily.
Regulators are tackling the shortcomings of the US equity market. The SEC is piloting circuit breakers that halt trading across stock exchanges for five minutes if the price of a share in the Russell 1000 index moves over 10% in a five-minute period. Alex Paley, director of algorithmic trading at broker Deutsche Bank, says the pilot scheme will need to evolve. “It's critical in terms of market microstructure that circuit breakers between equities and equity derivatives are homogenous and that the circuit breakers are somewhat more advanced than the simplistic breaker level of 10% that is currently set.”
According to Paley, circuit breakers should be designed to deal with improbable circumstances, such as an entire market falling at the same time by several percentage points, rather than being set against simple measures of change in a stock price. The simplicity of the circuit breakers was blamed for a halt in trading of Citi stock on 29 June.
The Financial Industry Regulatory Authority and the SEC have established clearer rules on breaking trades to limit firm's exposure and uncertainty under extreme conditions. On 18 September, three equity markets, the New York Stock Exchange, Nasdaq and BATS Exchange, applied to the SEC to prevent market makers from making prices outside of 8% of the best bid offer price at that time, effectively banning stub quotes.
General counsel at broker and market maker Knight Capital Leonard Amoruso says his firm fully backs these proposals. “We think staying 2% within the circuit breakers is a good first step but there needs to be additional obligations.”
Along with fellow market makers Getco and Virtu Financial, Knight proposed similar measures in a submission to the SEC on 13 July, with further obligations including quoting inside of the spread for a certain length of time, and quoting three to five price levels below best bid offer to increase liquidity depth.
But progress on regulatory reform is slow. The SEC had already proposed changes to transaction reporting, non-displayed markets, market access and other aspects of the equities market structure before the Dodd-Frank act landed on its plate in July.
As for that ”trigger trade', Ted Myerson, president of risk management technology firm FTEN, believes that proposed SEC regulations on pre-trade risk management could in future prevent algorithms from being used wrongly or from going wrong. “The algorithm used was like putting oxygen on a flame. It was just the wrong algo. You have to have pre-trade or at-trade tests on a per-trade basis so a firm will know if it has a crazy algo, an algo going crazy or the wrong algo being used,” said Myerson.