Flash Crash report part 5
WHAT HAPPENED?
May 6 started as an unusually turbulent day for the markets. As discussed in more detail in the
Preliminary Report, trading in the U.S opened to unsettling political and economic news from
overseas concerning the European debt crisis. As a result, premiums rose for buying protection
against default by the Greek government on their sovereign debt. At about 1 p.m., the Euro
began a sharp decline against both the U.S Dollar and Japanese Yen.
Around 1:00 p.m., broadly negative market sentiment was already affecting an increase in the
price volatility of some individual securities. At that time, the number of volatility pauses,
also known as Liquidity Replenishment Points (“LRPs”), triggered on the New York Stock
Exchange (“NYSE”) in individual equities listed and traded on that exchange began to
substantially increase above average levels.
By 2:30 p.m., the S&P 500 volatility index (“VIX”) was up 22.5 percent from the opening
level, yields of ten-year Treasuries fell as investors engaged in a “flight to quality,” and selling
pressure had pushed the Dow Jones Industrial Average (“DJIA”) down about 2.5%.
Furthermore, buy-side liquidity in the E-Mini S&P 500 futures contracts (the “E-Mini”), as
well as the S&P 500 SPDR exchange traded fund (“SPY”), the two most active stock index
instruments traded in electronic futures and equity markets, had fallen from the early-morning
level of nearly $6 billion dollars to $2.65 billion (representing a 55% decline) for the E-Mini and
from the early-morning level of about $275 million to $220 million (a 20% decline) for SPY.4
Some individual stocks also suffered from a decline their liquidity.
At 2:32 p.m., against this backdrop of unusually high volatility and thinning liquidity, a large
fundamental trader (a mutual fund complex) initiated a sell program to sell a total of 75,000 EMini
contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position.
Generally, a customer has a number of alternatives as to how to execute a large trade. First, a
customer may choose to engage an intermediary, who would, in turn, execute a block trade or
manage the position. Second, a customer may choose to manually enter orders into the
market. Third, a customer can execute a trade via an automated execution algorithm, which
can meet the customer’s needs by taking price, time or volume into consideration. Effectively,
a customer must make a choice as to how much human judgment is involved while executing a
trade.
This large fundamental trader chose to execute this sell program via an automated execution
algorithm (“Sell Algorithm”) that was programmed to feed orders into the June 2010 E-Mini
market to target an execution rate set to 9% of the trading volume calculated over the previous
minute, but without regard to price or time.
The execution of this sell program resulted in the largest net change in daily position of any
trader in the E-Mini since the beginning of the year (from January 1, 2010 through May 6,
2010). Only two single-day sell programs of equal or larger size – one of which was by the
same large fundamental trader – were executed in the E-Mini in the 12 months prior to May 6.
When executing the previous sell program, this large fundamental trader utilized a
combination of manual trading entered over the course of a day and several automated
execution algorithms which took into account price, time, and volume. On that occasion it
took more than 5 hours for this large trader to execute the first 75,000 contracts of a large sell
program.
However, on May 6, when markets were already under stress, the Sell Algorithm chosen by
the large trader to only target trading volume, and neither price nor time, executed the sell
program extremely rapidly in just 20 minutes.
This sell pressure was initially absorbed by:
• high frequency traders (“HFTs”) and other intermediaries in the futures market;
• fundamental buyers in the futures market; and
• cross-market arbitrageurs who transferred this sell pressure to the equities
markets by opportunistically buying E-Mini contracts and simultaneously
selling products like SPY, or selling individual equities in the S&P 500 Index.
HFTs and intermediaries were the likely buyers of the initial batch of orders submitted by the
Sell Algorithm, and, as a result, these buyers built up temporary long positions. Specifically,
HFTs accumulated a net long position of about 3,300 contracts. However, between 2:41 p.m.
and 2:44 p.m., HFTs aggressively sold about 2,000 E-Mini contracts in order to reduce their
temporary long positions. At the same time, HFTs traded nearly 140,000 E-Mini contracts or
over 33% of the total trading volume. This is consistent with the HFTs’ typical practice of
trading a very large number of contracts, but not accumulating an aggregate inventory beyond
three to four thousand contracts in either direction.
The Sell Algorithm used by the large trader responded to the increased volume by increasing
the rate at which it was feeding the orders into the market, even though orders that it already
sent to the market were arguably not yet fully absorbed by fundamental buyers or crossmarket
arbitrageurs. In fact, especially in times of significant volatility, high trading volume is
not necessarily a reliable indicator of market liquidity.
What happened next is best described in terms of two liquidity crises – one at the broad index
level in the E-Mini, the other with respect to individual stocks. |
