Contents

§ Background [ edit ]

On May 6, U.S. stock markets opened and the Dow was down, and trended down for most of the day on worries about the debt crisis in Greece. At 2:42 pm, with the Dow Jones down more than 300 points for the day, the equity market began to fall rapidly, dropping an additional 600 points in 5 minutes for an almost 1,000-point loss on the day by 2:47 pm. Twenty minutes later, by 3:07 pm, the market had regained most of the 600-point drop. [ 6 ]

§ Explanation [ edit ]

§ SEC/CFTC Report on May 6, 2010 [ edit ]

After almost five months of investigations led by Gregg E. Berman, [ 7 ] [ 8 ] the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) issued a joint report dated September 30, 2010 and titled Findings Regarding the Market Events of May 6, 2010 identifying the sequence of events leading to the Flash Crash. [ 9 ]

The joint report portrayed a market so fragmented and fragile that a single large trade could send stocks into a sudden spiral, [ 10 ] and detailed how a large mutual fund firm selling an unusually large number of E-Mini S&P 500 contracts first exhausted available buyers, and then how high-frequency traders (HFT) started aggressively selling, accelerating the effect of the mutual fund’s selling and contributing to the sharp price declines that day. [ 10 ] [ 11 ] [ 12 ] [ 13 ] [ 14 ] [ 15 ] [ 16 ] [ 17 ]

The SEC and CFTC joint report itself says that May 6 started as an unusually turbulent day for the markets and that by the early afternoon broadly negative market sentiment was already affecting an increase in the price volatility of some individual securities. At 2:32 pm (EDT), against a backdrop of unusually high volatility and thinning liquidity that day, a large fundamental trader (a mutual fund complex) initiated a sell program to sell a total of 75,000 E-Mini S&P 500 contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position. The report says that this was an unusually large position and that the computer algorithm the trader used to trade the position was set to target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time. [ 9 ]

As the large seller’s trades were executed in the futures market, buyers included high-frequency trading firms – trading firms that specialize in high-speed trading and rarely hold on to any given position for very long – and within minutes these high-frequency trading firms also started aggressively selling the long futures positions they first accumulated mainly from the mutual fund. [ 10 ] The Wall Street Journal quoted the joint report, ‘HFTs [then] began to quickly buy and then resell contracts to each other—generating a ‘hot-potato ‘ volume effect as the same positions were passed rapidly back and forth.’ [ 10 ] The combined sales by the large seller and high-frequency firms quickly drove the E-mini price down 3% in just four minutes. [ 10 ]

From the SEC/CFTC report itself:

The combined selling pressure from the sell algorithm, HFTs, and other traders drove the price of the E-Mini S&P 500 down approximately 3% in just four minutes from the beginning of 2:41 pm through the end of 2:44 pm. During this same time cross-market arbitrageurs who did buy the E-Mini S&P 500, simultaneously sold equivalent amounts in the equities markets, driving the price of SPY (an exchange-traded fund which represents the S&P 500 index) also down approximately 3%. 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. [ 9 ]

As prices in the futures market fell, there was a spillover into the equities markets. The computer systems used by most high-frequency trading firms to keep track of market activity decided to pause trading, and those firms then scaled back their trading or withdrew from the markets altogether. [ 10 ] [ 11 ] [ 12 ] [ 13 ]

The New York Times then noted, Automatic computerized traders on the stock market shut down as they detected the sharp rise in buying and selling. [ 12 ] As computerized high-frequency traders exited the stock market, the resulting lack of liquidity caused shares of some prominent companies like Procter & Gamble and Accenture to trade down as low as a penny or as high as $100,000. [ 12 ] These extreme prices also resulted from market internalizers, [ 18 ] [ 19 ] [ 20 ] firms that usually trade with customer orders from their own inventory instead of sending those orders to exchanges, routing ‘most, if not all,’ retail orders to the public markets – a flood of unusual selling pressure that sucked up more dwindling liquidity. [ 13 ]

While some firms exited the market, firms that remained in the market exacerbated price declines because they ‘escalated their aggressive selling’ during the downdraft. [ 10 ] High-frequency firms during the crisis, like other firms, were net sellers, contributing to the crash. [ 11 ] [ 12 ] [ 13 ]

The joint report continued: At 2:45:28 pm, trading on the E-Mini was paused for five seconds when the Chicago Mercantile Exchange (‘CME’) Stop Logic Functionality was triggered in order to prevent a cascade of further price declines. In that short period of time, sell-side pressure in the E-Mini was partly alleviated and buy-side interest increased. When trading resumed at 2:45:33 pm, prices stabilized and shortly thereafter, the E-Mini began to recover, followed by the SPY. [ 9 ] After a short while, as market participants had time to react and verify the integrity of their data and systems, buy-side and sell-side interest returned and an orderly price discovery process began to function, and by 3:00 pm (EDT), most stocks had reverted back to trading at prices reflecting true consensus values. [ 9 ]

§ Early theories [ edit ]

CME Group. a large futures exchange. stated that, insofar as stock index futures traded on CME Group were concerned, its investigation found no evidence that high-frequency trading played a role, and in fact concluded that automated trading had contributed to market stability during the period of the crash. [ 21 ] Others speculate that an intermarket sweep order may have played a role in triggering the crash. [ 22 ]

1. The fat-finger theory: In the immediate aftermath of the plunge, several reports indicated that the event may have been triggered by a fat-finger trade. an inadvertent large sell order for Procter & Gamble stock, inciting massive algorithmic trading orders to dump the stock; however, this theory was quickly disproved after it was determined that Procter and Gamble’s decline occurred after a significant decline in the E-mini S&P 500 Futures contracts. [ 23 ] [ 24 ] [ 25 ] The fat-finger trade hypothesis was also disproved when it was determined that existing CME Group and ICE safeguards would have prevented such an error. [ 26 ]
2. Impact of high frequency traders: Regulators found HFT’s exacerbated price declines. As noted above, regulators found that high frequency traders exacerbated price declines. Regulators determined that high frequency traders sold aggressively to eliminate their positions and withdrew from the markets in the face of uncertainty. [ 10 ] [ 11 ] [ 12 ] [ 13 ] A July 2011 report by the International Organization of Securities Commissions (IOSCO), an international body of securities regulators, concluded that while algorithms and HFT technology have been used by market participants to manage their trading and risk, their usage was also clearly a contributing factor. [ 27 ] [ 28 ] Other theories postulate that the actions of high frequency traders (HFTs) were the underlying cause of the flash crash. One hypothesis, based on the analysis of bid-offer data by Nanex. Llc. is that HFTs send non-executable orders (orders that are outside the bid-offer spread ) to exchanges in batches. Though the purpose of these orders is unknown, some experts speculate that their purpose is to increase noise, clog exchanges, and outwit competitors. [ 29 ] However, other experts believe that deliberate market manipulation is unlikely because there is no practical way in which the HFTs can profit from these orders, and it is more likely that these orders are designed to test latency times and to detect early price trends. [ 30 ] Whatever the reasons behind the possible existence of these orders, this theory postulates that they exacerbated the crash by overloading the exchanges on May 6. [ 29 ] [ 30 ] On September 3, 2010, the regulators probing the crash concluded: that quote-stuffing – placing and then almost immediately cancelling large numbers of rapid-fire orders to buy or sell stocks – was not a ‘major factor’ in the turmoil. [ 31 ] Some have put forth the theory High-frequency trading actually has been a major factor in minimizing and reversing the flash crash. [ 32 ]
3. Large directional bets: Regulators say a large E-Mini S&P 500 seller set off a chain of events triggering the Flash Crash, but did not identify the firm. [ 10 ] [ 11 ] [ 12 ] [ 13 ] Earlier, some investigators suggested that a large purchase of put options on the S&P 500 index by the hedge fund Universa Investments shortly before the crash may have been among the primary causes. [ 33 ] [ 34 ] Other reports have speculated that the event may have been triggered by a single sale of 75,000 E-mini S&P 500 contracts valued at around $4 billion by the Overland Park. Kansas firm Waddell & Reed on the Chicago Mercantile Exchange. [ 35 ] Others suspect a movement in the U.S. Dollar to Japanese Yen exchange rate. [ 36 ]
4. Changes in market structure: Some market structure experts speculate that, whatever the underlying causes, equity markets are vulnerable to these sort of events because of decentralization of trading. [ 29 ]
5. Technical glitches: An analysis of trading on the exchanges during the moments immediately prior to the flash crash reveals technical glitches in the reporting of prices on the NYSE and various alternative trading systems (ATSs) that might have contributed to the drying up of liquidity. According to this theory, technical problems at the NYSE led to delays as long as five minutes in NYSE quotes being reported on the Consolidated Quotation System (CQS) with time stamps indicating that the quotes were current. However, some market participants (those with access to NYSE’s own quote reporting system, OpenBook) could see both correct current NYSE quotes, as well as the delayed but apparently current CQS quotes. At the same time, there were errors in the prices of some stocks (Apple Inc. Sothebys, and some ETFs). Confused and uncertain about prices, many market participants attempted to drop out of the market by posting stub quotes (very low bids and very high offers) and, at the same time, many high-frequency trading algorithms attempted to exit the market with market orders (which were executed at the stub quotes) leading to a domino effect that resulted in the flash crash plunge. [ 37 ] [ 38 ]

§ Criticism of the SEC-CFTC report [ edit ]

A few hours after the release of the 104 pages SEC-CFTC report, a number of critics stated that blaming a single order (from Waddell & Reed ) for triggering the event was disingenuous. Most prominent of all, the CME issued within 24 hours a rare press release in which it argued against the SEC-CFTC explanation:

Futures and options markets are hedging and risk transfer markets. The report references a series of bona fide hedging transactions, totaling 75,000 contracts, entered into by an institutional asset manager to hedge a portion of the risk in its $75 billion investment portfolio in response to global economic events and the fundamentally deteriorating market conditions that day. The 75,000 contracts represented 1.3% of the total E-Mini S&P 500 volume of 5.7 million contracts on May 6 and less than 9% of the volume during the time period in which the orders were executed. The prevailing market sentiment was evident well before these orders were placed, and the orders, as well as the manner in which they were entered, were both legitimate and consistent with market practices. These hedging orders were entered in relatively small quantities and in a manner designed to dynamically adapt to market liquidity by participating in a target percentage of 9% of the volume executed in the market. As a result of the significant volumes traded in the market, the hedge was completed in approximately twenty minutes, with more than half of the participant’s volume executed as the market rallied – not as the market declined. Additionally, the aggregate size of this participant’s orders was not known to other market participants. Additionally, the most precipitous period of market decline in the E-Mini S&P 500 futures on May 6 occurred during the 3½ minute period immediately preceding the market bottom that was established at 13:45:28. During that period, the participant hedging its portfolio represented less than 5% of the total volume of sales in the market. [ 39 ]

Dr. David Leinweber, director of the Center for Innovative Financial Technology at Lawrence Berkeley National Laboratory. was invited by the Journal of Portfolio Management to write an editorial, in which he openly criticized the government’s technological capabilities and inability to study today’s markets. Dr. Leinweber wrote:

The heads of the SEC and CFTC often point out that they are running an IT museum. They have photographic evidence to prove it—-the highest-tech background that The New York Times (on September 21, 2010) could find for a photo of Gregg Berman, the SEC’s point man on the Flash, was a corner with five PCs, a Bloomberg, a printer, a fax, and three TVs on the wall with several large clocks. A better measure of the inadequacy of the current mélange of IT antiquities is that the SEC/CFTC report on the May 6 crash was released on September 30, 2010. Taking nearly five months to analyze the wildest ever five minutes of market data is unacceptable. CFTC Chair Gensler specifically blamed the delay on the “enormous” effort to collect and analyze data. What an enormous mess it is. [ 40 ]

Nanex. a leading firm specialized in the analysis of high-frequency data, also pointed out to several inconsistencies in the CFTC study:

Based on interviews and our own independent matching of the 6,438 W&R executions to the 147,577 CME executions during that time, we know for certain that the algorithm used by W&R never took nor required liquidity. It always posted sell orders above the market and waited for a buyer; it never crossed the bid/ask spread. That means that none of the 6,438 trades were executed by hitting a bid. [. ] [S]tatements from page 36 of Kirilenko’s paper cast serious doubt on the credibility of their analysis. [. ] It is widely believed that the sell program refers to the algo selling the W&R contracts. However, based on the statements above, this cannot be true. The sell program must be referring to a different algo, or Kirilenko’s analysis is fundamentally flawed, because the paper incorrectly identifies trades that hit the bid as executions by the W&R algo. [ 41 ]

§ Academic research [ edit ]

Order flow toxicity (measured as CDF[VPIN]) was at historically high levels one hour prior to the flash crash