Not since the Warren Commission Report was released in 1964 has a governmental report been received with such skepticism as the report on the May 6 flash crash by the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC).
At least a half dozen industry leaders have volunteered opinions on that report during my interviews for our Top 50 Brokers story and during public panels at the Futures Industry Association’s Futures & Options Expo recently held in Chicago. All of them doubted the conclusions of the report that placed the blame on a lone E-mini S&P trade by a mutual fund.
To recap the SEC/CFTC report states that a 75,000-lot automated sell order in the E-mini S&P 500 market placed by a mutual fund company triggered the flash crash. It has been widely reported that the mutual Fund company was Kansas City based Waddell & Reed. The report goes into great detail on the trade and how it set off a series of dominoes but misses the point by not focusing on the dominoes.
I haven’t seen the trade logs and I am not expert enough to deconstruct the market actions but I view the report with skepticism as well. Not so much in the conclusion that a large sell order entered in the E-mini S&P 500 market created the spark that lit the fuse, I guess it could have, but that the report summary focused on the details of that trade and not the larger issue, which is the thousands of unrealistic prices in the securities markets that followed.
After all the E-mini S&P 500 is not the market that produced 60% moves and worse — multiple individual equities trading at a penny or $100,000. The S&Ps dropped less than 10% for the day at the bottom and about 5% during the roughly 15-minute flash crash. The report notes that there were more than 20,000 trades across more than 300 securities executed at prices more than 60% away from pre-flash crash levels. The damaging lack of confidence in the market is the result of those outrageous prices not anything that happened in the S&Ps. It seems the report should have focused more on why that happened. If the E-mini trade was the spark it should have been noted and they should have moved on to the more worrisome aspects of the event.
That is also the opinion of Interactive Brokers CEO Tom Peterffy. “They put a whole lot of emphasis on this order from Waddell & Reed that caused the market to spike. I don’t think that was the problem with the flash crash, the problem with the flash crash was that some ETFs and stocks went down 50, 60, 70, 80, 100%,” Peterffy says. “The SEC/CFTC report was full time talking about the Waddell & Reed story and there was very little mention about what happened in certain stock and ETFs and why.”
The report ominously points out that the order was placed “without regard to price or time” as if that were a crime. It is not. The trade had an execution algorithm set to sell at a rate of 9% of the trading volume calculated over the previous minute. That seems to make sense as no one want to become too large of a seller and in affect chase the market down. But at the same time you want to execute your trade. Stop limit orders have their place but what happens if the market continues to go down? You are stuck with a much worse fill.
As noted in this blog and in the SEC/CFTC report, the market was under stress. I wrote at the time many analysts were expecting a correction of 10% or greater. This mutual fund appeared to be attempting to take some risk off the table and protect some of the profits earned over the historic rally from the March 2009 low.
The report does talk about the myriad of unconnected circuit breakers in other markets and the practice of stub quoting (the ability not to meet your market making obligation) but they seem secondary, at least in the summary. In fact the first thing mentioned under “Lessons Learned” at the end of the summary is a reference to not taking price into consideration in automated sell algorithms. They need to get over that. It does mention that the five-second pause as part of CME Group’s stop logic functionality allowed the market to stabilize and the remainder of that large sell order was executed as the market rallied. Maybe that would have been a good time for them to change their focus instead of simply blaming futures.
If the 75,000-lot sell order by Waddell & Reed is in deed the spark that ignited the flash crash, it was the disorganized nature of various circuit breakers, failure of market makers to make markets, suspension of routing orders to NBBO (National best bid/offer), stub quoting and perhaps the practice of internalization in the securities markets that were the oily rags in the garage that created the conflagration. Peterffy told us that a study of the report showed many of the penny prices were actually labeled short sales coming from internalizers rerouting orders to the market.
The report talks about two liquidity crises: one in the E-minis and the other in the securities market as arbitraguers attempted to offset their long S&P positions . I am not sure if CME agrees it experienced a liquidity crisis and it is pretty clear that its Stop Logic Functionality did precisely what it was supoposed to do.
Staying with our spark analogy, markets are volatilie and will produce many sparks. After the Great Chicago Fire we did not make laws to prevent sparks or cows or meteors for that matter but changed the building codes so that a single spark would not lead to a huge conflagration. That is what the regulators need to do. Don't focus on the spark because there will be many more and they are unavoidable, focus on why certain markets could not handle the heavy flow of orders that spark produced.