The long-awaited federal report about the "flash crash" was supposed to end speculation about what caused the stock market to quake for several hair-raising minutes during the afternoon of May 6. Instead, it is sparking fresh debates about what sent the Dow Jones Industrial Average plunging nearly 1,000 points only to recover most of those losses in a matter of minutes.
The 104-page report from the Securities and Exchange Commission and the Commodity Futures Trading Commission explores in excruciating detail what happened during roughly 20 minutes of market mayhem, concluding that a single mutual fund company triggered the crash, using a computer program for the automated sale of 75,000 futures contracts tied to the Standard & Poor’s 500-stock index, known as E-Minis. Regulators didn’t name the company that initiated the trade, but it has been widely reported to be Waddell & Reed Financial, Inc., in Overland Park, Kan. Waddell has said only that it didn’t intend to "disrupt" the market.
The question is whether a sale of 75,000 contracts, representing a tiny fraction of 5.7 million contracts traded on the Chicago Mercantile Exchange that day, could have sent the market into a meltdown, and whether the report is merely shifting the blame from the regulators themselves. Although it was a huge sale, representing some $4.1 billion in market value, the CME, in a press release Friday after the joint report was made public, noted that half the trade occurred as the market rallied from its lows on May 6. The SEC-CFTC report itself said of the 75,000 contracts sold, only about 35,000 were sold during the market’s plunge.
Some found it hard to believe regulators’ claim that a sale of 35,000 E-Minis tipped the scales from a severe sell-off to one of the worst trading days ever, when high-priced stocks like Apple fell to pennies a share before recovering. ZeroHedge, a financial blog that’s often critical of regulators, pointed out that daily volume in the days leading up to the crash was three million contracts. "The SEC expects [people] to believe that a block that … accounted for around 2.5 percent of recent daily volume caused the flash crash?" the site asked.
But high-frequency traders, a corner of the market that received a great deal of attention after the flash crash, seized on the report to support their position. Some of these fast-moving firms pulled out of the market when stocks began to behave erratically on May 6, which may have worsened the decline. High-frequency traders, who can buy and sell big blocks of stock in seconds using computers, often take the other side of a trade when another investor wishes to buy or sell. Industry watchers estimate that high-frequency traders now make up about two-thirds of daily market volume.
"The trader at Waddell & Reed showed historic incompetence," Dave Cummings, CEO of Tradebot Systems, a Kansas City, Mo., high-speed firm, wrote in an email to a number of market participants. The algorithm executing the trade, he says, should have been sensitive to large price movements, backing off if prices moved sharply. Instead, it was designed to accelerate sales when market volume rose — as it did in dramatic fashion — and ignore prices. "It angers me when people blame technology for what are clearly lapses in human judgment," Mr. Cummings wrote.
Others think regulators may have been attempting to deflect attention away from another suspected culprit in the crash: themselves. Steve Wunsch, a market-structure consultant and longtime critic of the SEC, maintains that the crash was the result of a convoluted market structure spawned by a series of regulations crafted by the SEC over more than a decade.
Those regulations have fragmented the market into multiple trading venues, curbing the influence of once powerful players such as the New York Stock Exchange and the Nasdaq Stock Market.
Ten years ago, the NYSE accounted for more than 80 percent of the trading volume of NYSE-listed stocks. Today, the exchange handles roughly one-quarter of those stocks. With trading volume spread out among multiple exchanges as well as "dark pools," off-exchange electronic trading platforms, and other venues, liquidity has been spread so thin that a flash crash was virtually preordained, Mr. Wunsch argues.
"Markets are supposed to be able to handle a big amount of selling," said Mr. Wunsch. He points out that while trading was heavy in futures markets, they didn’t experience the same dramatic price swings as stock markets on May 6. He also thinks that high-speed traders had every right to pull out of a market that was becoming chaotic. Blaming them misses the bigger point that the market structure itself is broken, he says.
"The big question is why did the flash crash happen in equities" and not other parts of the market, he said. "The answer is that if we hadn’t changed the market structure in the last 10 years, it wouldn’t have happened."
Of course, the old market structure didn’t always work perfectly either. On Oct. 19, 1987, otherwise known as Black Monday, the market crashed more than 20 percent. One of the triggers: heavy selling of futures contracts in Chicago that spilled over into the stock market.
Related Links:
Legacy of the "Flash Crash" (The Wall Street Journal)
Air Pocket Economy Takes Stocks on a Wild Ride (The Fiscal Times)
Billionaire Calls Flash Crash a Regulatory Failure (Forbes)
