A number of theories have been put forth to explain the brief but severe drop in prices that occurred on May 6, 2010. Over the last two weeks the staffs of the U.S. Commodity Futures Trading Commission (CFTC) and the U.s. Securities & Exchange Commission (SEC) have been investigating the drop and released their preliminary findings to the Joint Advisory Committee on Emerging Regulatory Issues yesterday.
According to the report, while the day was already facing doubts concerning the European debt crisis, leading to significant, but not extraordinary losses, the rapid decline and subsequent rapid recovery was a result of “a temporary breakdown in the supply of liquidity across the markets.”
The report goes on to explore the possibility of a linkage between the decline in the prices of stock index products such as the E-mini S&P 500 futures and the simultaneous and subsequent waves of selling in individual securities. It additionally examines the impact the NYSE’s liquidity replenishment points (LPRs) may have played as well as the impact stop loss market orders and short sales all combined to affect the market.
Further, the report found that the use of stub quotes may have exasperated the situation. Stub quotes work as a place holder for market makers when they do not have enough liquidity available to trade a stock near its recent price range. In order to comply with requirements a stub quote, often a bid as low as a penny, would be entered so as not to bid beyond their liquidity. On May 6, though, as other bids were either filled or cancelled stub quotes that were never intended to be processed were executed.
These factors, when taken as a whole, point to a possible source for the loss of liquidity experienced, leading to the dramatic hiccough in prices.
Additionally, the report worked to lay other hypotheses to rest. “We have found no evidence that these events were triggered by ‘fat finger’ errors, computer hacking, or terrorist activity, although we cannot completely rule out these possibilities.”
The CFTC and SEC staffs reached these conclusions after analyzing price, time, and volume data on over 19 billion shares executed on May 6. “Staff analysis of market performance measures is consistent with the conclusion that a very temporary, but serious liquidity shortage occurred across the securities and futures markets,” the report said.
The complete 151-page document is available online from the CFTC.