The automated sale of stock futures without regard to price and “hot potato” trading by computer- driven firms that briefly created an illusion of liquidity helped trigger the May 6 crash, turning an orderly selloff into an $862 billion rout as buy orders evaporated, U.S. regulators said in a report released today.
“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,” according to the report from the Securities and Exchange Commission and Commodity Futures Trading Commission.
A large trader’s routine attempt to hedge against losses helped set off a chain of events that sent the Dow Jones Industrial Average down 998.50 points, according to the 104-page report released today. While the report doesn’t name the seller, two people with knowledge of the findings said it was Waddell & Reed Financial Inc. The mutual-fund company’s action may not have caused a crash if there weren’t already concern in the market about the European debt crisis, the people said.
“When you don’t put a limit price on orders, that’s what can happen,” said Paul Zubulake, senior analyst at Boston-based research firm Aite Group LLC. “This is not a manipulation or an algorithm that ran amok. It was told to be aggressive and not use a price. The market-making community actually absorbed a lot of the selling, but then they had to hedge their own risk.”
Millionths of a Second
Regulators are facing pressure from investors to explain whether trading rules have failed to keep pace with markets that now handle order executions in millionths of a second. SEC Chairman Mary Schapiro is trying to protect investors in a fragmented U.S. stock market while maintaining liquidity -- the ease with which investors can buy and sell shares -- on venues dominated by firms that profit from computerized trading.
“Some market makers and other liquidity providers widened their quote spreads, others reduced offered liquidity, and a significant number withdrew completely from the markets,” according to today’s report. High-frequency traders, “who normally both provide and take liquidity as part of their strategies, traded proportionally more as volume increased, and overall were net sellers in the rapidly declining broad market along with most other participants.”
Destabilized Trading
Lawmakers such as Sen. Ted Kaufman, a Democrat from Delaware, have asked if high-frequency firms in the stock market, which have supplanted specialists and market makers with strategies that transact thousands of shares a second, destabilized trading by withdrawing their liquidity when they were needed most.
Schapiro said earlier this month that regulators should examine increased obligations for market makers providing orders to buy and sell stocks. The SEC and CFTC found in their initial report about May 6 that electronic trading firms supplying bids and offers reined in their activity, increasing the “mismatch of liquidity” and potentially exacerbating the decline.
Waddell & Reed, based in Overland Park, Kansas, is the trader that sold E-mini futures on the Standard & Poor’s 500 Index, helping start the crash, according to two people familiar with the matter. E-minis are contracts offered by CME Group Inc. that let investors bet on things such as the S&P 500.
250 Firms
“We believe we were one of 250 firms engaging in E-mini trading during the period of the market selloff,” Waddell & Reed said in the question-and-answer-style statement first released in May. “We believe that trades of the size we initiated normally are absorbed easily in the market.”
Roger Hoadley, a spokesman for the company, said the statement was “still accurate and relevant.”
The report highlighted the challenges faced by institutional investors trying to gauge liquidity, or the number of buyers and sellers, in a business dominated by computerized market makers. Waddell & Reed’s initial sales of E-Mini futures spurred a flurry of volume -- 140,000 contracts -- among high- frequency traders who began balancing their inventory with corresponding sales. The increase in trading caused Waddell & Reed’s algorithm, programmed to align its orders with volume in the market, to sell more.
Fluctuated Near Zero
“Net holdings of HFTs fluctuated around zero so rapidly that they rarely held more than 3,000 contracts long or short on that day,” the report said. “Moreover, compared to the three days prior to May 6, there was an unusually high level of ‘hot potato’ trading volume -- due to repeated buying and selling of contracts -- among the HFTs,” it said. Between 2:45:13 p.m. and 2:45:27 p.m. New York time, “HFTs traded over 27,000 contracts, which accounted for about 49 percent of the total trading volume, while buying only about 200 additional contracts net.”
The report added: “The sell algorithm used by the large fundamental seller 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 cross-market arbitrageurs. In fact, especially in times of significant volatility high trading volume is not a reliable indicator of market liquidity.”
Some high-speed trading firms began assessing whether the rapid price moves were the result of erroneous data and how their systems were keeping up with the high volume of data, according to the report. They also sought to determine what impact the moves had on their risk and position limits and their profitability, and how the prospect of trades being canceled would affect their holdings.
‘Cataclysmic event’
“A number of participants reported that because prices simultaneously fell across many types of securities, they feared the occurrence of a cataclysmic event of which they were not yet aware, and that their strategies were not designed to handle,” the report said. Some of these firms widened their quote spreads, or the difference between the price they were willing to buy a security and the level at which they would sell. Others pared back the liquidity they were providing. “A significant number withdrew completely from the markets,” the report said.
The report said the E-mini trade amounted to 75,000 contracts, valued at about $4.1 billion. Only two sell programs in E-mini futures amounting to at least 75,000 contracts had occurred in the 12 months before May 6, including one by the same firm, the report said. In that instance, it took the trader more than five hours to execute that many contracts.
Markets Under Stress
“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,” the report said. Algorithms are automated strategies that break up larger orders into smaller pieces to avoid swaying the market price. Some algorithms funnel orders into the market based on the average amount of trading over a period of time.
The declines fed into the stock markets. To combat selling in one security or market from spreading, exchanges implemented circuit breakers in June that pause trading in more than 1,300 securities during periods of volatility. They have also adopted uniform policies for canceling trades and are eliminating stub quotes, or bids and offers to execute at prices far away from the stock’s last sale.
Circuit Breakers
“SEC staff will evaluate the operation of the circuit breaker program and the new procedures for breaking erroneous trades” through the pilot program, which lasts until Dec. 10, according to today’s SEC-CFTC report. “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.”
The circuit breakers and new order-cancelation process have helped safeguard markets, Bart Chilton, a CFTC commissioner, said in an interview today on Bloomberg Television.
“We’re safer today than we were on May 6,” he said. “We need to harmonize our rules and regulations. These are Band-Aid fixes.”
While the report stressed the need to coordinate rules among equity venues in the U.S., it said most market participants said one system to slow down trading unique to the New York Stock Exchange didn’t have a direct impact on their ability to buy and sell. More than 1,000 securities triggered liquidity replenishment points, an NYSE system that switches from electronic trading to automated auctions overseen by humans, lasting more than 1 second in the half hour starting at 2:30 p.m. on May 6, the report said. That compared with a normal daily average of 20 to 30.
Not ‘Trapped’
Firms told regulators that their systems automatically adjust for slow quotes on the NYSE Euronext venue by routing to other exchanges. The agencies also noted that since 80 percent of the 326 securities having broken trades weren’t listed on NYSE, it’s unlikely that buy and sell orders “trapped” on the Big Board would have mitigated the selloff.
“Participants did not report they had difficulty routing or felt their orders were ‘trapped’ as a result of LRP events,” the study said. “However, a number of market participants told us that the fact so many LRPs were being triggered further underscored the severity of market conditions as they were unfolding, and that this additional ‘evidence’ played into their decisions to reduce liquidity, pause trading, or withdraw from the market.”
Today’s report doesn’t include policy recommendations.
“A lot of people were expecting more guidance and more regulations,” said Frank Ingarra, a Stamford, Connecticut-based money manager at Hennessy Advisors Inc., which oversees about $900 million. “Maybe the good thing is this gives time for the governing body to go through and digest it and the reaction. Now maybe the next step is they’ll be able to say, ‘OK, here’s what we’re going to do.’”
To contact the reporters on this story: Nina Mehta in New York at nmehta24@bloomberg.net; Michael P. Regan in New York at mregan12@bloomberg.net; Jesse Westbrook in Washington at jwestbrook1@bloomberg.net.
To contact the editors responsible for this story: Nick Baker at nbaker7@bloomberg.net; Lawrence Roberts at lroberts13@bloomberg.net.
http://jodnet.blogspot.com
“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,” according to the report from the Securities and Exchange Commission and Commodity Futures Trading Commission.
A large trader’s routine attempt to hedge against losses helped set off a chain of events that sent the Dow Jones Industrial Average down 998.50 points, according to the 104-page report released today. While the report doesn’t name the seller, two people with knowledge of the findings said it was Waddell & Reed Financial Inc. The mutual-fund company’s action may not have caused a crash if there weren’t already concern in the market about the European debt crisis, the people said.
“When you don’t put a limit price on orders, that’s what can happen,” said Paul Zubulake, senior analyst at Boston-based research firm Aite Group LLC. “This is not a manipulation or an algorithm that ran amok. It was told to be aggressive and not use a price. The market-making community actually absorbed a lot of the selling, but then they had to hedge their own risk.”
Millionths of a Second
Regulators are facing pressure from investors to explain whether trading rules have failed to keep pace with markets that now handle order executions in millionths of a second. SEC Chairman Mary Schapiro is trying to protect investors in a fragmented U.S. stock market while maintaining liquidity -- the ease with which investors can buy and sell shares -- on venues dominated by firms that profit from computerized trading.
“Some market makers and other liquidity providers widened their quote spreads, others reduced offered liquidity, and a significant number withdrew completely from the markets,” according to today’s report. High-frequency traders, “who normally both provide and take liquidity as part of their strategies, traded proportionally more as volume increased, and overall were net sellers in the rapidly declining broad market along with most other participants.”
Destabilized Trading
Lawmakers such as Sen. Ted Kaufman, a Democrat from Delaware, have asked if high-frequency firms in the stock market, which have supplanted specialists and market makers with strategies that transact thousands of shares a second, destabilized trading by withdrawing their liquidity when they were needed most.
Schapiro said earlier this month that regulators should examine increased obligations for market makers providing orders to buy and sell stocks. The SEC and CFTC found in their initial report about May 6 that electronic trading firms supplying bids and offers reined in their activity, increasing the “mismatch of liquidity” and potentially exacerbating the decline.
Waddell & Reed, based in Overland Park, Kansas, is the trader that sold E-mini futures on the Standard & Poor’s 500 Index, helping start the crash, according to two people familiar with the matter. E-minis are contracts offered by CME Group Inc. that let investors bet on things such as the S&P 500.
250 Firms
“We believe we were one of 250 firms engaging in E-mini trading during the period of the market selloff,” Waddell & Reed said in the question-and-answer-style statement first released in May. “We believe that trades of the size we initiated normally are absorbed easily in the market.”
Roger Hoadley, a spokesman for the company, said the statement was “still accurate and relevant.”
The report highlighted the challenges faced by institutional investors trying to gauge liquidity, or the number of buyers and sellers, in a business dominated by computerized market makers. Waddell & Reed’s initial sales of E-Mini futures spurred a flurry of volume -- 140,000 contracts -- among high- frequency traders who began balancing their inventory with corresponding sales. The increase in trading caused Waddell & Reed’s algorithm, programmed to align its orders with volume in the market, to sell more.
Fluctuated Near Zero
“Net holdings of HFTs fluctuated around zero so rapidly that they rarely held more than 3,000 contracts long or short on that day,” the report said. “Moreover, compared to the three days prior to May 6, there was an unusually high level of ‘hot potato’ trading volume -- due to repeated buying and selling of contracts -- among the HFTs,” it said. Between 2:45:13 p.m. and 2:45:27 p.m. New York time, “HFTs traded over 27,000 contracts, which accounted for about 49 percent of the total trading volume, while buying only about 200 additional contracts net.”
The report added: “The sell algorithm used by the large fundamental seller 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 cross-market arbitrageurs. In fact, especially in times of significant volatility high trading volume is not a reliable indicator of market liquidity.”
Some high-speed trading firms began assessing whether the rapid price moves were the result of erroneous data and how their systems were keeping up with the high volume of data, according to the report. They also sought to determine what impact the moves had on their risk and position limits and their profitability, and how the prospect of trades being canceled would affect their holdings.
‘Cataclysmic event’
“A number of participants reported that because prices simultaneously fell across many types of securities, they feared the occurrence of a cataclysmic event of which they were not yet aware, and that their strategies were not designed to handle,” the report said. Some of these firms widened their quote spreads, or the difference between the price they were willing to buy a security and the level at which they would sell. Others pared back the liquidity they were providing. “A significant number withdrew completely from the markets,” the report said.
The report said the E-mini trade amounted to 75,000 contracts, valued at about $4.1 billion. Only two sell programs in E-mini futures amounting to at least 75,000 contracts had occurred in the 12 months before May 6, including one by the same firm, the report said. In that instance, it took the trader more than five hours to execute that many contracts.
Markets Under Stress
“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,” the report said. Algorithms are automated strategies that break up larger orders into smaller pieces to avoid swaying the market price. Some algorithms funnel orders into the market based on the average amount of trading over a period of time.
The declines fed into the stock markets. To combat selling in one security or market from spreading, exchanges implemented circuit breakers in June that pause trading in more than 1,300 securities during periods of volatility. They have also adopted uniform policies for canceling trades and are eliminating stub quotes, or bids and offers to execute at prices far away from the stock’s last sale.
Circuit Breakers
“SEC staff will evaluate the operation of the circuit breaker program and the new procedures for breaking erroneous trades” through the pilot program, which lasts until Dec. 10, according to today’s SEC-CFTC report. “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.”
The circuit breakers and new order-cancelation process have helped safeguard markets, Bart Chilton, a CFTC commissioner, said in an interview today on Bloomberg Television.
“We’re safer today than we were on May 6,” he said. “We need to harmonize our rules and regulations. These are Band-Aid fixes.”
While the report stressed the need to coordinate rules among equity venues in the U.S., it said most market participants said one system to slow down trading unique to the New York Stock Exchange didn’t have a direct impact on their ability to buy and sell. More than 1,000 securities triggered liquidity replenishment points, an NYSE system that switches from electronic trading to automated auctions overseen by humans, lasting more than 1 second in the half hour starting at 2:30 p.m. on May 6, the report said. That compared with a normal daily average of 20 to 30.
Not ‘Trapped’
Firms told regulators that their systems automatically adjust for slow quotes on the NYSE Euronext venue by routing to other exchanges. The agencies also noted that since 80 percent of the 326 securities having broken trades weren’t listed on NYSE, it’s unlikely that buy and sell orders “trapped” on the Big Board would have mitigated the selloff.
“Participants did not report they had difficulty routing or felt their orders were ‘trapped’ as a result of LRP events,” the study said. “However, a number of market participants told us that the fact so many LRPs were being triggered further underscored the severity of market conditions as they were unfolding, and that this additional ‘evidence’ played into their decisions to reduce liquidity, pause trading, or withdraw from the market.”
Today’s report doesn’t include policy recommendations.
“A lot of people were expecting more guidance and more regulations,” said Frank Ingarra, a Stamford, Connecticut-based money manager at Hennessy Advisors Inc., which oversees about $900 million. “Maybe the good thing is this gives time for the governing body to go through and digest it and the reaction. Now maybe the next step is they’ll be able to say, ‘OK, here’s what we’re going to do.’”
To contact the reporters on this story: Nina Mehta in New York at nmehta24@bloomberg.net; Michael P. Regan in New York at mregan12@bloomberg.net; Jesse Westbrook in Washington at jwestbrook1@bloomberg.net.
To contact the editors responsible for this story: Nick Baker at nbaker7@bloomberg.net; Lawrence Roberts at lroberts13@bloomberg.net.
http://jodnet.blogspot.com
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