The eagerly awaited report on the causes of the May 6 "flash crash" portrayed a market so fragmented and fragile that a single large trade could send stocks into a sudden spiral.
The report, released by federal regulators on Friday, went further than many in the market had expected by pinpointing one trade by a mutual-fund company as a key contributing factor to the market's plunge.
Regulators say that the firm— which was Overland Park, Kan.-based Waddell & Reed Financial Inc., according to people familiar with the trading—chose to sell a big number of futures contracts using a computer program that essentially ended up wiping out available buyers in the market.
A spokesman for Waddell refused to comment beyond the firm's previous statement from May, in which the firm said it doesn't intend to "disrupt" markets through its trading.
The 104-page report by the staffs of the Securities and Exchange Commission and the Commodity Futures Trading Commission said high-frequency traders quickly magnified the impact of the mutual fund's selling. Among other points, the report shows six of 12 high-frequency trading firms remained in the market as stocks began to crash. However, those firms took "significant" buying power out of the market. As well, the report plays down the impact of data delays and a shutdown of the links between some exchanges, which the SEC directly oversees.
While the report hadn't been expected to make policy recommendations, it only lightly touched on how rules from the SEC and other regulators set the stage for a market implosion. Since May 6, the SEC is testing rules designed to briefly halt trading in individual stocks during sharp moves or to prevent them moving beyond a certain percentage limit.
Joe Saluzzi, co-head of equity trading at Themis Trading, an agency brokerage, said he was disappointed by the narrow focus on the large trade, rather than a set of proposals for how to prevent a similar crash. "All you got here is five months after the fact, you have an analysis of 15 minutes of trading," said Mr. Saluzzi. "If this were to occur again, it would take another five months to figure it out."
The report lays out the backdrop to the flash crash, noting May 6 began "as an unusually turbulent day," with the markets roiled by the European debt crisis. By 2:30 p.m. Eastern time, the Dow Jones Industrial Average was down about 276 points.
At 2:32 p.m., a trader at Waddell & Reed placed a huge order to sell E-mini futures contracts, which mimic movements in the S&P 500-stock index. This kind of trade wasn't unusual for Waddell, which at the time managed some $25 billion, including the popular Ivy Asset Strategy Fund. As part of the fund's strategy, the firm from time-to-time places bets that the broad stock market will fall as a hedge against its individual stock holdings.
Also not unusual was that Waddell placed the trade using a computer program known as a trading "algorithm" designed to stand in for a human trader and parse out buying or selling based on different variables. Generally, traders opt for algorithms that consider trading volume, price changes and the amount of time to complete a trade.
But Waddell's desk opted for an algorithm designed to sell 75,000 E-mini contracts at a pace that would range up to 9% of trading volume—and not take into account other factors. The report details how a similar-size trade earlier in 2010 took five hours to execute, but in this case, the Waddell trade unloaded on the market in just 20 minutes.
As the Waddell trade hit the futures markets, the joint report said, the likely buyers included high-frequency trading firms. A key feature of high-frequency trading firms is that they quickly exit trades and, by 2:41, they were also aggressively selling the E-mini contracts they had bought from Waddell, which was still trying to sell the remainder of its contracts.
Meanwhile, long-term buyers were out of the market in the midst of the selloff.
"HFTs 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," the report says. At one point, HFTs traded more than 27,000 contracts in just 14 seconds—a huge amount.
The Waddell algorithm responded to the high volume by picking up the pace of its selling, even though stocks were spiraling lower.
This feedback loop of selling by Waddell, high-frequency traders and others helped drive the E-mini price down 3% in just four minutes.
The report cited this episode as a "key lesson" of the report: "Especially in times of significant volatility, high trading volume is not necessarily a reliable indicator of market liquidity."
A CFTC official called the execution of the trade "unfortunate" and said it "effectively resulted in the erosion" of liquidity in the E-mini contract, which was exacerbated by other market players. He said it wasn't clear whether the flash crash would have been avoided without the trade.
CME Group Inc., operator of the futures exchange, questioned the report's focus on the large E-mini trade. "The report I think is skewed wrong, because it talks too much about that [trade], but if you read it, you see our market worked," CME Chairman Emeritus Leo Melamed said.
The selloff in the futures market then spilled over to the market for individual stocks. And as conditions worsened, the liquidity in the market evaporated because the automated systems used by most firms to keep pace with the market paused when prices began falling drastically.
Overall, the report painted a nuanced picture of the role of high-frequency trading firms, some of which acknowledged pulling out of the market that day.
Since May 6, regulators have questioned whether these superactive traders should have any obligation to keep trading amid a crisis.
Friday's report found that of the 12 largest high-frequency firms, six scaled back trading during some portion of the afternoon's plunge.
In addition to several firms pulling out of the market, those remaining "escalated their aggressive selling" during the downdraft.
While focusing on the role of Waddell and high-frequency traders, the report went easier on stock exchanges, which the SEC regulates.
The report said delays in data from the New York Stock Exchange's electronic-trading arm, Arca, contributed to some traders' "decision to curtail or halt trading." The NYSE's decision to "go slow," or switch trading in some stocks from electronic to human auction, didn't cause significant difficulties in order-routing but did spook participants and played into their decision to pause trading or withdraw from the markets, the report said.
And the move by Nasdaq OMX Group Inc. to bypass NYSE Arca, effectively routing orders around it in response to concerns about NYSE operations, added to concerns about abnormal trading, the report said.
But it concluded that all of these events didn't play a "dominant role" in the flash crash.
Representatives of NYSE Euronext and Nasdaq declined to discuss details of the report. An NYSE spokesman called it "an important step" in understanding the events of May 6 and "outlining the challenges" in improving the markets, and cited as evidence of improvements recent proposals to synchronize exchanges' rules governing halting of trades and the obligations of market makers.
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