During the May 6 "flash crash," CME Group’s stop logic functionality was triggered and trading in the CME’s E-mini S&P futures was paused for five seconds. The CME says that this pause permitted market participants to provide much needed liquidity by entering, modifying or canceling orders." Unfortunately, this protocol does not exist across all markets and oddly the Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC) determined in its report released Oct. 1, that the trigger for the flash crash was a 75,000 lot E-mini trade entered by a mutual fund.
In the report, the Commissions acknowledge the markets were already facing a great deal of anxiety and volatility because of growing concerns over the European sovereign debt situation, but finger the catalyst as a single sell order of 75,000 S&P E-mini contracts (approximately $4.1 billion value) traded at the Chicago Mercantile Exchange (CME). While the report did not name the source of the trade, other media sources identified the mutual fund Waddell & Reed.
While the report identifies a single trade as the trigger for the move, the move was well under way prior to the order. "To blame the ‘flash crash’ on a single trader is unfair. While that was the impetus for the market to spike lower, on the equity side there are no uniform cancelation policies, technology differences between the venues as well as retail investors placing stop losses with no limit orders," says Paul Zubulake, senior analyst at Aite Group. "I don’t think you can say one particular thing caused it."
"Throughout the day, CME Group markets functioned properly," CME Group noted in a release following the report. "Our automated credit controls, order quantity limitations, stop and market order price protection points, price banding procedures, and stop logic functionality operated as designed and were effective in responding to challenging market conditions."
They also noted that more than half of the large order was executed as the market was rallying from the low, adding, "The orders, as well as the manner in which they were entered, were both legitimate and consistent with market practices."
According to the report, the fund selected a sell algorithm that was programmed to feed orders into the market with an execution rate set to 9% of the trading volume calculated over the previous minute, "but without regard to price or time."
The entire 75,000 contracts were sold within 20 minutes. What followed was a chain of events that saw arbitrage between the E-mini contract on the futures side and the S&P 500 SPDR exchange traded fund on the equities, and ultimately resulted in the sharp movements we saw that day.
Once trades were moved to the equity markets, problems were only exasperated. "It’s really an equity market problem. In the futures market, even though the CME allows market orders, they are all tied to the no-bust range," Zubulake says. "The equity markets are a mess with their rules and no uniformity."
At this point, though, knowing what sparked the movement creates other concerns for the markets. "I find it somewhat disconcerting that a company that [is sizable, but not huge] could have this type of effect," says Jay Gould, head of the investment funds practice at Pillsbury. "What kind of problems could larger institutions bring to the market? Couple that with the fact that it took the regulators this long to get it figured out."
The report showed just how interconnected the markets have become. "Now that we understand what has happened, it is surprising that it hasn’t happened before to this degree and it is probably quite likely it will happen again," Gould says.