On May 6, 2010, the U.S. equity markets experienced a dramatic fall and subsequent recovery in prices in what has since become known as the "flash crash." In a joint report released on September 29, the CFTC and SEC identified a single order in the futures market that they claim to be the source of the unusual events observed in the stock market on this day.
According to the Report, What Happened?
As rioting broke out in Athens over the Greek parliament's approval of austerity measures to avert default, markets were already trending downward. At 2:32 pm ET, a mutual funds manager used a trading algorithm to sell 75,000 CME E-mini futures contracts at 9% of volume in order to hedge a position. Then, at 2:40 pm, prices began declining rapidly until 2:45:28 pm, when the CME Stop Logic paused trading in the E-minis for five seconds. At this time, 35,000 contracts of the 75,000 had been executed. By the time trading in the E-minis resumed, liquidity had recovered, prices stabilized and the remaining 40,000 contracts were executed in a relatively orderly fashion.
Both buy and sell-side liquidity in stocks dramatically declined starting at about 2:40 pm as traders stepped away due to their inclination that markets were not behaving normally. In 300 securities, liquidity was reduced to such an extent that they traded at prices more than 60% away from their prices just before the crash. These trades were later cancelled under the "clearly erroneous" trade rules, with ETFs representing the majority of broken trades.
The "Flash Crash" was Due to a Reduction in Liquidity, Not Just One Large Futures Seller
Based on our research, we do not find pinning the only cause of the "flash crash" to a single order satisfying. While the CME E-mini futures order could be considered large, it was not unduly so given that the average volume in E-mini futures exceeds 1 million contracts per day. Using the 9% participation rate sited by the report, the "large fundamental seller" would only be selling 12,600 contracts against the 140,000 traded by HFTs between 2:41 and 2:44 pm. (Although the report does not specify, the HFT number may have been double counted, so the number traded by the algorithm could actually have even been less than 12,600.) Given that 140,000 is a gross number with only 2000 net sold, selling 12,600 contracts in this environment on a normal day would hardly cause markets to spiral. In fact, market structure contributed greatly to keeping the E-mini trading orderly. The CME's limit down rules were triggered, resulting in a pause that provided market participants a chance to re-evaluate; the E-minis consequently stabilized and recovered. In fact, the CME points out that the order was comparatively small relative to market volume:
"The 75,000 contracts represented 1.3% of the total E-Mini 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... 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."1
In our opinion, given the facts stated by both the SEC report and the CME, the sell order could not be the singular cause of the crash. However, the interconnection among markets, the order and the method with which it was executed likely served as a catalyst for the reduction in liquidity and the "erroneous" stock trades experienced seconds later.
In stocks, both buy and sell side liquidity reduced dramatically. Page 33 of the CFTC/SEC report shows liquidity in S&P 500 stocks over the day. Liquidity on both sides cratered starting at about 2:40 pm, causing a number of securities to trade at egregiously low and high prices. We conclude that the "flash crash" was a liquidity event, unsupported by the prevailing market structure.
Had the market been less fragile or the futures algorithm less aggressive, the HFT method of transferring risk into stocks by offsetting futures purchases with SPY sales would have helped absorb this E-mini futures sale and moved liquidity between asset classes.
Why did the Futures Markets Retain Order while the Stock Markets Crashed?
Put simply, market structure prevented equity stocks from recovering in the orderly manner that the futures did. The CME has Stop Logic functionality which forces market participants to take a five second pause after a certain degree of price movement. This pause provided ample time for market participants to consider their positions and return to the market or not depending on the conclusions they reached. In this way, the limit down functionality imposed a moment of control and pause that stemmed the fall of the futures and allowed market participants to regain confidence. As we observed, liquidity quickly returned to the futures market as traders saw a buying opportunity and placed orders during the pause.
Without circuit breakers in individual stocks and because the lateness of the day prevented market- wide circuit breakers from triggering, there was nothing to stem the tide of falling equity prices in these order-driven markets. As a potential remedy, the single-stock circuit breaker pilot program may present a positive initiative to address the issues observed on May 6th. Regulators also need to be able to recognize the correlations between markets and asset classes so they can coordinate preventive measures. For example, it may be worth considering whether the E-minis and Spiders should go limit up or down at the same price trigger level as part of a coordinated pause. Tighter market-wide circuit breakers could have provided support in this case. Given their wide limits, the circuit breakers that were in place would not have been triggered even if the time of the crash had been earlier in the day.
Impact for Buy-Side Traders: Know Your Algorithms
The report concludes that, "under stressed market conditions, the automated execution of a large sell order can trigger extreme price movements, especially if the automated execution algorithm does not take prices into account." While we don't think that the initial E-mini order should be attributed as the singular force creating the sell-off, it is worth noting that the first "lesson learned" cited by the report could be read as a warning against using algorithms that send orders based only on volume without price controls. An algorithm that adjusts its aggressiveness based on price level and/or has a price limit provides an important layer of intelligence and protection. More advanced logic to address message traffic and short term price movements may have allowed detection of the "hot potato" volume situation referenced in the report, where HFTs traded more volume than usual with each other and could have signalled abnormal market conditions. If the algorithms contributing to the problem on May 6th had been more sensitive to market conditions and aware of the type of volume being traded, they would likely not have been so aggressive.
[Further insight to the CFTC/SEC Report is available in Bob Giffords' report "Flash Crash - The Hunt for Weapons of Market Destruction"]
1CME Group Statement on the Joint CFTC/SEC Report Regarding the Events of May 6.