In a September 30, 2010 report to the Joint Advisory Committee on Emerging Regulatory Issues, the staffs of the CFTC and the SEC detailed their findings regarding the market events of May 6, 2010. The report reflects the culmination of market data analysis and interviews with various market participants and exchanges regarding the events of May 6, and describes the events in terms of two liquidity crises.
The report states that on May 6, the markets opened turbulently on news of the European debt crisis. When the Euro began a sharp decline against the U.S. Dollar and Japanese Yen, volatility pauses on the New York Stock Exchange and the S&P 500 volatility index both increased, yields of ten-year Treasuries decreased, the Dow Jones Industrial Average fell, and there was a drop in both buy-side liquidity in E-Mini S&P 500 futures contracts and the SPDR S&P 500 ETF Trust (SPY).
The report describes the first liquidity crisis at the broad index level in the E-Mini. According to the report, against the backdrop of turbulent market conditions, a large fundamental trader entered an order to sell 75,000 E-Mini contracts via an automated execution algorithm at an execution rate calculated based on trading volume without regard to price or time. During this time, high frequency traders traded E-Mini contracts comprising nearly 33% of the total trading volume, which triggered the algorithm, feeding additional contracts into the market even though fundamental buyers in the futures market and cross-market arbitrageurs had not absorbed the previous orders.
According to the report, a series of factors, including sell pressure from the algorithm, lack of demand from fundamental buyers and cross-market arbitrageurs and a “hot potato” volume effect as high frequency traders rapidly traded the same positions back and forth, contributed to rapid declines in the prices of the E-Mini and SPY. The sudden decline in price and liquidity triggered a five-second regulatory trading pause. From the start of the algorithm until the trading pause, the algorithm sold 35,000 contracts. During the same time, all fundamental sellers combined sold more than 80,000 contracts, resulting in a net imbalance of 30,000 contracts. As the prices stabilized, the algorithm continued to sell the remaining 40,000 contracts.
The report describes the second liquidity crisis with respect to individual stocks. According to the report, in reaction to the E-Mini crisis, the automated trading systems used by many liquidity providers also paused as designed to allow traders and risk managers to perform a risk assessment of continued trading. As a result, some market makers and liquidity providers widened quote spreads, reduced liquidity and a significant number withdrew from the markets. The reduced liquidity caused further price declines until eventually, liquidity evaporated in a number of individual securities and ETFs. Those participants instructed to trade at market found no interest, resulting in trades during this time being executed at prices ranging from 1¢ to $100,000. After market close, the exchanges and FINRA later agreed to cancel trades that were executed at a price more than 60% away from their value prior to the market events under their “clearly erroneous” trade rules.
In response to the May 6 events and to provide clarity around when erroneous trades will be broken, regulators established the circuit breaker program and related procedures. The report states that the CFTC and SEC staffs will work with market centers to review their members’ trading practices to identify any abusive or manipulative conduct that may cause system delays that inhibit a fair and orderly process of price discovery.