Was it those guys in Chicago?

There have been a number of theories floated regarding what caused last Thursday’s “flash crash” in equity markets but to date no one has provided a definitive explanation.

The first story was that someone keyed in “B” for billion instead of “M” for million on an equity order in Procter & Gamble. P&G was one of the first stocks where odd price behavior was observed, which is probably the essence of that rumor. That has never been confirmed and I am not sure of any system that accept orders that way, most you must enter the numeric value — hence the term fat fingered error (holding down the zero key for an extra beat increasing the order X10, X100 or X1,000). A larger broker dealer that was cited in several stories denied that a fat fingered error by one of its traders was the cause of the crash.

The next set of rumors have surrounded the CME Group’s E-mini contract and talk that large sell orders in the E-mini S&P 500 set the markets lower. The CME released a statement  noting, “CME Group markets functioned properly yesterday despite significant market activity due to global macroeconomic conditions and apparent problems that resulted in the cancellation or ‘busting’ of securities transactions by The NASDAQ Stock Market and the NYSE Arca in coordination with all other UTP Exchanges.”  

 There doesn’t seem to me much to that rumor beyond equity market participants’ automatic reflex of trying to blame the futures markets for their problems. Anyone remember the 1987 crash?

Commodity Futures Trading Commission Chairman Gary Gensler has not ingratiated himself to the industry since taking the post but did defend it in testimony before the House Committee on Financial Services yesterday regarding the “flash crash.”

 In fact Gensler —  perhaps unintentionally, perhaps not — took a shot at the equity side with the following comment during his testimony: “…Requiring that stop orders have a limit avoids the potential that such stop orders could be executed no matter how low the market goes. This requirement for all stop orders to convert to limit orders prevents, for example, any stop orders from being posted at a price unreasonably below the market, such as orders at a price of one cent.”

 He rather humorously points out that though futures markets exhibited volatility, it did not produce the type of crazy anomalies that can create a loss of confidence in the markets. It is hard to understand someone making the case that a drop in an index can cause one of the equities within it to exhibit unrealistic prices, which occurred in several stock such as Exelon going down to a penny.

 In fact, one of our technical analyst contributors commenting on this noted”… I found that in all cases, major indices and futures markets stopped going down in the right place implying there was universal symmetry.”

 A more likely contributing factor is the NYSE Euronext’s mini circuit breakers called “Liquidity Replenishment Periods (LRPs). The LRPs are initiated during high volatility in specific securities.

 By all accounts — and so far there have been few — the LRPs did their job. The exchange turns off its auto execution function for stocks in LRP mode and orders are directed to the DMM (Designated Market Maker). The NYSE did not bust any trades and none of the ridiculous prints occurred on the NYSE. The problem is that when they go to LRP mode in certain issues, other exchanges no longer direct orders their way. This means they are no longer part of the National Best Bid/Offer (NBBO) and the overall market is less liquid as a result. One of the initial recommendations being bandied about is that these mini circuit breakers, as the LRPs are called, should be universal across all equity markets.

 Perhaps that is a solution but we need to know how this happened before offering solutions.

 One thing that should be clear is that markets that produced non realistic prices should not be blaming markets that didn’t.

About the Author
Daniel P. Collins

Editor-in-Chief of Futures Magazine, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange. Dan joined Futures in 2001 and in 2005 he was promoted to Managing Editor, responsible for overseeing all the content that went into Futures and futuresmag.com. Dan’s incisive reporting and no-holds barred commentary places him among the most recognized national media figures covering futures, derivative trading and alternative investments.

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