'Flash crash' report: A tale of how not to make a big trade

The May 6 'flash crash' of the stock market was set off by a single $4.1 billion 'sell' order, the SEC reported Friday.

Pablo Martinez Monsivais/AP
From right, Commodity Futures Trading Commission Chairman Gary Gensler, Federal Reserve Chairman Ben Bernanke, Treasury Secretary Timothy Geithner, FDIC Chair Sheila Bair, and Securities and Exchange Commission Chair Mary Schapiro, meet Friday at the Treasury Department in Washington.

The US stock market briefly went haywire on May 6, and a key reason for this so-called "flash crash" was a single large "sell" order, according to a report Friday by the US Securities and Exchange Commission (SEC).

It's a cautionary tale about the complexity and potential vulnerability of America's financial markets. But in the end, it's also a simple lesson for large and small investors alike: If you're going to trade, be careful how you do it.

At the heart of the incident, as the report recounts, was a single poorly designed trade. As a result, many stock prices swung sharply downward just after 2:30 p.m. and then shot upward to recover most of those losses by 3 p.m.

"A customer [investor] has a number of alternatives as to how to execute a large trade," said the report, prepared by the Commodity Futures Trading Commission (CFTC) as well as the SEC. "This large [mutual fund company] chose to execute this sell program via an automated execution algorithm ... without regard to price or time."

The mutual fund company is not named in the report, but independent media accounts have identified the firm as Waddell & Reed in Overland Park, Kansas.

The trade was a sell order on "E-Mini" contracts on the future price of the Standard & Poor's 500 stock index. It misfired for three reasons:

  • It was a large order, "the largest net change in daily position of any trader in the E-Mini since the beginning of the year," the SEC said. This came on a bad day, when investors were already tense -- and selling -- due to negative news about the European debt crisis.
  • The algorithm was set up so the firm would keep selling regardless of price. When prices veered into territory that was irrationally low, based on the consensus view of traders that day, the selling continued.
  • The computerized trade was also set up with no speed limit, so the selling pressure surged through the market at a speed that made it hard for other players to respond. By contrast, when the same company placed a large sell order some months earlier, the algorithms "took into account price, time, and volume" and the trade unfolded over a period of at least five hours.

The 104-page report doesn't answer all of the mysteries of May 6 – why some securities swung much more wildly than others, for example.

But it does go into new detail about how the E-Mini trade rippled through financial markets.

The big sell order sparked price swings in broad market indexes and indirectly in individual stocks. Firms that normally provide liquidity – buying securities when others sell – pulled back. Then, over time, various investors stepped in with buy orders as they concluded that the rapid plunge in stock prices did not reflect fundamental news.

The Dow Jones Industrial Average, which was down as much as 9 percent for the day in mid-afternoon, ended the day with a loss of 3 percent, about the same as its level just before Waddell & Reed put its trade in motion.

The large order, placed at 2:32 p.m., was to sell a total of 75,000 E-Mini contracts, a total trade worth about $4.1 billion. The algorithm was set up to keep selling contracts, as long as trading volume was strong, until all those contracts were sold. As a result, the algorithm ended up selling the whole bundle in just 20 minutes, with sales flowing faster than other firms could absorb them.

In reporting on the events of May 6, the SEC produced a "what happened" document, rather than detailed prescriptions for how markets can function better.

Still, the agency pointed to some broad lessons, and said its report confirmed the wisdom of a new "circuit breaker" system that the SEC and exchanges have put in place since May 6.

"May 6 was ... an important reminder of the inter-connectedness of our derivatives and securities markets, particularly with respect to index products," the report concluded. The E-Mini, as a futures contract, is considered a derivative investment.

Another lesson is that a liquidity crisis can develop in ad hoc fashion, as various firms pause from trading due to their own criteria. They aren't knowingly contributing to a market meltdown, but it becomes a problem if many buyers take a pause when there's also high selling pressure.

The circuit breaker concept involves a mandated pause in trading, which gives various players time to get back on top of a volatile situation. It puts the market on hold at a time when some traders might be taking a pause anyway, due to uncertainty.

What's new since May 6 is circuit breakers for trading in individual securities, not just for the overall market (if major indexes take a rapid plunge). Trading in a stock will halt for five minutes if that security has experienced a 10 percent price change during the preceding five minutes.

The SEC has also worked with exchanges since May to develop a more systematic approach to resolving "erroneous trades." In the past, regulators have canceled some trades after the fact, when they concluded that transaction prices were far outside normal bounds for a given day. But the process has been controversial and because traders can gain or lose from these "broken trades."

Like the new circuit breakers, the process for broken trades is in effect on a pilot basis for now, through Dec. 10.

Even with those steps, the events of May 6 have raised doubts among many small investors about whether markets are reliable and fair.

SEC Chairman Mary Schapiro and CFTC Chairman Gary Gensler issued a brief joint statement Friday designed to assure investors that they are on the case: "We now must consider what other investor-focused measures are needed to ensure that our markets are fair, efficient and resilient, now and for years to come."

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