Flash Crash report part 8
LESSONS LEARNED
The events summarized above and discussed in greater detail below highlight a number of key
lessons to be learned from the extreme price movements observed on May 6.
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.
May 6 was also an important reminder of the inter-connectedness of our derivatives and
securities markets, particularly with respect to index products. The nature of the cross-market
trading activity described above was confirmed by extensive interviews with market
participants (discussed more fully herein), many of whom are active in both the futures and
cash markets in the ordinary course, particularly with respect to “price discovery” products
such as the E-Mini and SPY. Indeed, the Committee was formed prior to May 6 in recognition
of the continuing convergence between the securities and derivatives markets, and the need for
a harmonized regulatory approach that takes into account cross-market issues. Among other
potential areas to address in this regard, the staffs of the CFTC and SEC are working together
with the markets to consider recalibrating the existing market-wide circuit breakers – none of
which were triggered on May 6 – that apply across all equity trading venues and the futures
markets.
Another key lesson from May 6 is that many market participants employ their own versions
of a trading pause – either generally or in particular products – based on different
combinations of market signals. While the withdrawal of a single participant may not
significantly impact the entire market, a liquidity crisis can develop if many market
participants withdraw at the same time. This, in turn, can lead to the breakdown of a fair and
orderly price-discovery process, and in the extreme case trades can be executed at stub-quotes
used by market makers to fulfill their continuous two-sided quoting obligations.
As demonstrated by the CME’s Stop Logic Functionality that triggered a halt in E-Mini
trading, pausing a market can be an effective way of providing time for market participants to
reassess their strategies, for algorithms to reset their parameters, and for an orderly market to
be re-established.
In response to this phenomenon, and to curtail the possibility that a similar liquidity crisis can
result in circumstances of such extreme price volatility, the SEC staff worked with the
exchanges and FINRA to promptly implement a circuit breaker pilot program for trading in
individual securities. The circuit breakers pause trading across the U.S. markets in a security
for five minutes if that security has experienced a 10% price change over the preceding five
minutes. On June 10, the SEC approved the application of the circuit breakers to securities
included in the S&P 500 Index, and on September 10, the SEC approved an expansion of the
program to securities included in the Russell 1000 Index and certain ETFs. The circuit breaker
program is in effect on a pilot basis through December 10, 2010.
A further observation from May 6 is that market participants’ uncertainty about when trades
will be broken can affect their trading strategies and willingness to provide liquidity. In fact, in
our interviews many participants expressed concern that, on May 6, the exchanges and FINRA
only broke trades that were more than 60% away from the applicable reference price, and did
so using a process that was not transparent.
To provide market participants more certainty as to which trades will be broken and allow
them to better manage their risks, the SEC staff worked with the exchanges and FINRA to
clarify the process for breaking erroneous trades using more objective standards.13 On
September 10, the SEC approved the new trade break procedures, which like the circuit
breaker program, is in effect on a pilot basis through December 10, 2010.
Going forward, SEC staff will evaluate the operation of the circuit breaker program and the
new procedures for breaking erroneous trades during the pilot period. As part of its review,
SEC staff intends to assess whether the current circuit breaker approach could be improved by
adopting or incorporating other mechanisms, such as a limit up/limit down procedure that
would directly prevent trades outside of specified parameters, while allowing trading to
continue within those parameters. Such a procedure could prevent many anomalous trades
from ever occurring, as well as limit the disruptive effect of those that do occur, and may work
well in tandem with a trading pause mechanism that would accommodate more fundamental
price moves.
Of final note, the events of May 6 clearly demonstrate the importance of data in today’s world
of fully-automated trading strategies and systems. This is further complicated by the many
sources of data that must be aggregated in order to form a complete picture of the markets
upon which decisions to trade can be based. Varied data conventions, differing methods of
communication, the sheer volume of quotes, orders, and trades produced each second, and
even inherent time lags based on the laws of physics add yet more complexity.
Whether trading decisions are based on human judgment or a computer algorithm, and
whether trades occur once a minute or thousands of times each second, fair and orderly
markets require that the standard for robust, accessible, and timely market data be set quite
high. Although we do not believe significant market data delays were the primary factor in
causing the events of May 6, our analyses of that day reveal the extent to which the actions of
market participants can be influenced by uncertainty about, or delays in, market data.
Accordingly, another area of focus going forward should be on the integrity and reliability of
market centers’ data processes, especially those that involve the publication of trades and
quotes to the consolidated market data feeds. In addition, we will be working with the market
centers in exploring their members’ trading practices to identify any unintentional or
potentially abusive or manipulative conduct that may cause system delays that inhibit the
ability of market participants to engage in a fair and orderly process of price discovery. |
