Thursday, May 6th, started with turbulent skies as the market digested significant news and information. Many financial news outlets were reporting on the uncertainties emanating out of Europe. In this environment of uncertainty, market participants started to require higher premiums to bear risk as indicated by a number of measures. One leading measure, called the VIX index, earlier in the week between Monday and Wednesday rose 23.4 percent and on Thursday rose another 31.7 percent, reflecting increased uncertainty among market participants. From Wednesday to its highest point on Thursday, the VIX index rose 63.3 percent. Premiums were higher on credit default swaps on many European sovereign debt securities, including debt of Greece, Portugal, Spain, Italy and Ireland. The broad U.S. equity market declined as the S&P fell nearly 2 percent from its previous day’s close by 2 PM.
The stock index futures markets and other markets are intertwined, and market participants in the stock index futures markets look for price signals from many places. By early in the afternoon, market participants would have seen indicator lights starting to flash in a number of places. Though we do not now know how these individual events motivated traders, looking back now, here are some of the market changes that occurred in the 20-30 minutes running up to the decline. Futures market participants likely would have observed some of these things. Currency markets were volatile. Small capitalization equity securities began declining sharply some time after 2:00. In fact, by 2:24, there were already eight closed-end mutual funds that had declined by 50 percent or more since 2:00.
We understand from our meetings with exchanges that by around 2:30, the exchanges were finding that their order books were thinning out as the markets became less liquid, while at the same time some investors were executing hedging strategies to protect themselves against a market decline. In the few minutes before 2:40 pm, two exchanges, Nasdaq and BATS declared “self-help” with respect to the New York Stock Exchange (NYSE) Arca Equities, an electronic trading platform. Self-help permits one trading center to bypass the quotes of another trading center if the affected center repeatedly fails to respond to orders within a one-second time period.
Around 2:40 pm, a number of individual securities listed on NYSE went into slow mode. Our current understanding is that, over the next five minutes, more than 10 additional individual securities entered into slow mode. These slow modes, or “liquidity replenishment points,” occur to enable market participants to interact with quotes and orders manually to enhance liquidity and reduce volatility.
From 2:40 to 2:45:28, the E-Mini declined by 58.25 points, reaching an intraday low of 1,056 – a decline of 5.2 percent. From the CFTC’s preliminary review of detailed intraday trading records and special call information, we understand that between 2:42 and 2:45, some of the most active traders limited their trading activity in the E-Mini futures contract. At 2:45:28, the CME’s stop-spike mechanism’s 5-second pause took effect. Following that pause, the contract’s price began to move upward.
We will continue to review the May 6 events, and in particular how S&P futures traded in relation to the cash markets and to exchange traded funds keyed to the same index. One of the highest volume
exchange traded funds is the SPDR1, which has a market capitalization of just less than $100 billion. Preliminary findings from the exchanges indicate the SPDR, which tracks the S&P 500, and the E-Mini futures contract were highly converged until the E-Mini started to rebound and the SPDR continued to decline another percent. In fact, we also saw that some stocks in the S&P 500 dropped faster than either the futures or the SPDR, such as 3M, and that, through the rally, the SPDR ETF was more volatile than the E-Mini. The S&P 500 and Nasdaq 100 cash indices reported their bottoms in the 2:46 minute.
By 2:49, the ETFs on the E-Mini, Dow Jones and S&P 500 had rebounded. By 2:50, the broad-based equity indices had recovered to near their 2:30 levels.
Through our review, we have learned that there were about 250 participants in the S&P E-Mini futures contract during the timeframe the market sold off. Of the 250, we have more closely focused our examination to date on the top ten largest longs and top ten shorts. The vast majority of these traders traded on both sides of the market, meaning they both bought and sold during that period – acting, essentially, as liquidity providers. One of these accounts was using the E-Mini contract to hedge and only entered orders to sell. That trader entered the market at around 2:32 and finished trading by around 2:51. The trader had a short futures position that represented on average nine percent of the volume traded during that period. The trader sold on the way down and continued to do so even as the price level recovered. This trader and others have executed hedging strategies of similar size previously.
Exchanges and market participants have stated their belief that it is unlikely that a “fat finger” mistake caused the heavy volatility of May 6. To date the CFTC staff review produced no evidence indicating that a “fat finger” was the catalyst.
Despite high volatility, the clearing and settlement for trading that took place on May 6 at CME and ICE US worked effectively and without incident, including the movement of funds that took place during the intra-day settlement cycle. The amount that the CME collected and paid to its clearing members as a result of the mark-to-market calculation for all CME contracts was slightly more than $4 billion; the amount collected and paid by ICE US to its clearing members was approximately $750 million. All margin calls were met on time, although there were no intra-day margin calls during the price spike. Clearing and settlement for trading that took place on CME and ICE US on Friday, May 7, 2010, also worked well.
Review by the CFTC in Coordination with the SEC
Since Thursday, the CFTC and the SEC have been actively coordinating efforts to review that day's unusual market activity. The agencies' market oversight and trading divisions have been in regular communication, exchanging insights, ideas and expertise.
This morning, the CFTC and SEC jointly announced the formation of a CFTC-SEC Advisory Committee on Emerging Regulatory Issues, which was proposed last fall as part of the SEC-CFTC Harmonization report. The Committee will take up as its first task a formal review of the events of last Thursday and make recommendations as appropriate. The Joint Advisory Committee, made up of market practitioners, academics and former regulators, will begin meeting shortly and will issue its review as soon as possible. The staff of the CFTC and SEC will provide to the Committee and Congress joint preliminary findings regarding last Thursday’s market events on Monday.
Independent from Thursday’s events, the CFTC currently is considering the implications of co-location and high-frequency trading. We also are considering a rule related to account identification so that the CFTC can collect better and more-detailed information on each trader in the futures markets.
Last Thursday’s events remind us of the need for one of the critical components of financial reform: bringing transparency to the over-the-counter derivatives markets so that regulators can also see what occurred in those markets.
I thank you again for inviting me to testify today. I look forward to your questions.