On October 1, the staffs of the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) released a joint report to the Joint Advisory Committee on Emerging Regulatory Issues presenting their findings regarding the severe market disruption of May 6, 2010. The report expands upon the preliminary report regarding the events of May 6, 2010 released by the staffs of the SEC and the CFTC on May 18, 2010. Readers of the October 1 report are encouraged to review the background discussion and analyses presented in the preliminary report.
The report concludes that a large trader’s use of a computer trading system to sell $4.1 billion of futures contracts in a 20-minute period led to a rapid and sudden selling that triggered additional sell-offs in an already unstable market. According to the report, the trader chose to use an algorithm to trade the E-mini futures contract, a contract that mimics trading in the S&P 500 stock index. According to the report, the computer program executed the trade “extremely rapidly in just 20 minutes.”
The report lays out the backdrop to the May 6, 2010 “flash crash,” noting that the day began “as an unusually turbulent day,” with the markets disturbed by the European debt crisis. By 2:30 p.m. Eastern time on May 6, 2010, the Dow Jones Industrial Average was down about 276 points.
At 2:32 p.m. on May 6th, the “large trader” initiated a sell program to sell a total of 75,000 E-Mini futures contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position, using a computer program known as a “trading algorithm” designed to stand in for a human trader and parse out buying or selling based on different variables. The trader opted for an algorithm designed to sell 75,000 E-mini contracts at a pace that would range up to 9% of trading volume—and not take into account other factors. According to the report, a similar-size trade earlier in 2010 took five hours to execute, while the May 6th trade was executed in just 20 minutes.
As the trade hit the futures markets, the joint report said, the likely buyers included high-frequency trading firms, or HFTs. A key feature of HFTs is that they quickly exit trades and, by 2:41 p.m., HFTs were also aggressively selling the E-mini contracts they had bought from the trader, which was still trying to sell the remainder of its contracts.
“HFTs began to quickly buy and then resell contracts to each other—generating a ‘hot-potato’ volume effect as the same positions were passed rapidly back and forth,” the report states. The trader’s algorithm responded to the high trading volume by picking up the pace of its selling, even though stocks were spiraling lower. This feedback loop of selling by the trader, HFTs and others helped drive the E-mini price down 3% in just four minutes.
According to the report, the selloff in the futures market eventually spilled over to the market for individual stocks. And as conditions worsened, the liquidity in the market evaporated because the automated systems used by most firms to keep pace with the market paused when prices began falling drastically.
In connection with the release of the report, SEC Chairman Mary L. Schapiro and CFTC Chairman Gary Gensler issued the following joint statement:
“We appreciate the incredible effort of all the professionals at both agencies who have worked tirelessly, scouring the data, interviewing market participants and reconstructing the events of May 6th. This report identifies what happened and reaffirms the importance of a number of the actions we have taken since that day. 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.”
Congressman Paul E. Kanjorski (D-PA), the Chairman of the House Financial Services Committee’s Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, convened the first congressional hearing on the May 6 market events on May 11, 2010. Chairman Kanjorski issued his own comments regarding the joint report, stating that “While automated, high-frequency trading may provide our markets with some benefits, it can also carry the potential for serious harm and market mischief. Extreme volatility of the kind we experienced on May 6 could happen again, as demonstrated by the volatility in individual stocks since then. To limit recurrences of that roller-coaster day and to bolster individual investor confidence, our regulators must expeditiously review and revise the rules governing market structure. Congress must also conduct oversight of these matters and, if necessary, put in place new rules of the road to ensure the fair, orderly and efficient functioning of the U.S. capital markets. The CFTC-SEC staff report will greatly assist in working toward these important policy goals.”