Well, the Securities and Exchange Commission and the Commodities Futures Trading Commission have released their joint report on the so-called “flash crash” of May 6.
The official report asserts that the crash wasn’t the result of market manipulation — a view the lead SEC investigator had previously expressed. According to regulators, falling liquidity levels in two broadly traded instruments and high volatility preceded the crash.
Furthermore, buy-side liquidity in the E-Mini S&P 500 futures contracts (the “E-Mini”), as well as the S&P 500 SPDR exchange traded fund (“SPY”), the two most active stock index instruments traded in electronic futures and equity markets, had fallen from the early-morning level of nearly $6 billion dollars to $2.65 billion (representing a 55% decline) for the E-Mini and from the early-morning level of about $275 million to $220 million (a 20% decline) for SPY. Some individual stocks also suffered from a decline their liquidity.
Then, a big investor (the agencies won’t say who it was, but we have a pretty good idea that it was Kansas-Based Waddell & Reed) sold $4.1 billion worth of e-mini futures. It was an unusually large and sudden sell order — at that point, the biggest seen in 2010. The sell order took the form of a computer algorithm that took trading volume, but not price or time, into account. The result was an extremely rapid sale of the futures contracts. At first, high-frequency traders, investors and others absorbed the sell orders. But soon, the high-frequency traders began selling off the contracts, and the big investor’s trading algorithm responded to the higher volume by accelerating its own selling.
Still lacking sufficient demand from fundamental buyers or cross-market arbitrageurs, HFTs began to quickly buy and then resell contracts to each other – generating a “hot-potato” volume effect as the same positions were rapidly passed back and forth. Between 2:45:13 and 2:45:27, HFTs traded over 27,000 contracts, which accounted for about 49 percent of the total trading volume, while buying only about 200 additional contracts net.
And as for the lessons learned:
One key lesson is that under stressed market conditions, the automated execution of a large sell order can trigger extreme price movements, especially if the automated execution algorithm does not take prices into account. Moreover, the interaction between automated execution programs and algorithmic trading strategies can quickly erode liquidity and result in disorderly markets. As the events of May 6 demonstrate, especially in times of significant volatility, high trading volume is not necessarily a reliable indicator of market liquidity.