Flash Crash Forensics

Abstract

ast spring, investors were jittery over negative economic news from Europe, specifically the debt crisis in Greece. And on the afternoon of 6 May, the major U.S. equity indices in both the futures and securities markets were already down more than 4 percent from their prior-day close when something freakish occurred. Suddenly, the indices plunged a further 5–6 percent but then rebounded to close down about 3 percent from the previous day. In the interim, more than 20,000 trades involving more than 300 securities were executed at prices more than 60 percent away from what their values had been only moments before. Many were executed at prices of a penny or less and some as high as US$100,000. Since then, the U.S. Securities and Exchange Commission (SEC) and the U.S. Commodities Futures Trading Commission (CFTC) have been plowing through volumes of market data to figure out what happened. Their final report released on 4 October explains the events leading up to what is now known as the Flash Crash. According to the report, at around 1:00 p.m. (EST) there was an above-average increase in the number of volatility pauses known as liquidity replenishment points (LRPs) that were triggered for individual stocks on the NYSE. By 2:30 p.m., the S&P 500 volatility index (VIX) had skyrocketed and buy-side liquidity in the E-mini S&P 500 futures contracts and the S&P 500 SPDR exchangetraded fund (SPY) fell 55 percent and 20 percent, respectively. At 2:32 p.m., a fundamental trading firm (not named in the report but subsequently identified by the Wall Street Journal and others as Waddell & Reed) initiated an automated program to sell 75,000 E-mini contracts to hedge an existing equity position. The algorithm was programmed to feed orders into the June 2010 E-mini market to target an execution rate set to 9 percent of the trading volume calculated over the previous minute but without regard to price or time. The firm’s strategy was executed in 20 minutes. On a previous occasion, Waddell & Reed combined manual trading with several algorithms to execute the strategy over the course of more than five hours, taking into account price, time, and volume. High-frequency traders (HFTs), fundamental buyers, and crossmarket arbitrageurs initially absorbed the selling, but liquidity soon vanished. At 2:45 p.m., the Chicago Mercantile Exchange Stop Logic Functionality was triggered, and the E-mini was paused for five seconds. Prices stabilized. Large market makers and liquidity providers use automated systems that are programmed with predefined trading parameters and thresholds. During the flash crash, many of these temporarily shut down as traders paused to assess market conditions and the associated risks. Some continued with manual trading in specific securities, which was a challenge because of the spike in volume. The HFTs were net sellers in the cash market for a time and then they disappeared altogether. Meanwhile, the internalizers (firms that cross trades internally) began routing orders directly to the public exchanges where liquidity was shallow. Market makers posted “stub quotes”—prices far away from the current market— to meet their continuous quoting obligations, and orders were executed against them. After the market closed, the exchanges and FINRA agreed to cancel all erroneous trades. These events highlight the extent to which automated sell orders can trigger extreme volatility and erode liquidity in stressed market conditions. The interconnectedness of the securities and derivatives markets requires a harmonized regulatory approach, particularly for recalibrating marketwide circuit breakers.