The first idea in the report, issued on May 18, is a possible link between the “precipitous decline” in the prices of stock index products – in particular the E-Mini S&P Index 500 Futures and index-tracking exchange-traded funds – and simultaneous and subsequent waves of selling of individual securities. The regulators said activity in one market may have led the others.

On the afternoon of May 6 in the US, the Dow Jones Industrial Average dropped nearly 1,000 points in minutes before recovering its losses.

The agencies’ investigation is focusing on events between 2pm and 3pm. Some 250 firms executed transactions in E-Mini S&P 500 Index Futures in that time, and the regulators are particularly looking at the 10 largest holders of both long and short positions.

The report highlighted one firm, which the SEC and CFTC said executed only sell orders between 2.32pm and 2.51pm. It held positions estimated by the regulators to be worth about 9% of transactions in the futures contract in the hour under investigation.

However, the CFTC and SEC said they were satisfied the firm was only engaging in a hedging strategy.

Waddell’s defence

The name of the firm has been the subject of much rumour. On May 15 Reuters named Kansas-based mutual fund manager Waddell & Reed as the mystery market participant. A spokesperson for Waddell declined to confirm or deny this, but the firm issued a statement confirming that it was one of the 250 active market participants.

The firm said: “On May 6, when the portfolio managers reached the conclusion that the risk of the European sovereign crisis extending to the United States and our financial system was increasing, they decided to reduce the funds’ equity exposure quickly. They used the E-Mini S&P 500 Index Futures contract as part of their equity hedging strategy. The E-Mini is highly liquid and widely traded. They sold E-Mini contracts to reduce equity exposure, and their trading was just 1% of overall trading volume on May 6 (75,000 of the 5.7m contracts traded that day). We believe we were one of 250 firms engaging in E-Mini trading during the period of the market selloff. Further, we believe that trades of the size we initiated normally are absorbed easily in the market.”

Waddell & Reed added: “While we executed a number of trades, the volume was not large relative to the overall depth of the market. We believe that the behaviour both of the price of the E-Mini and the bid/ask spread on the E-Mini also do not suggest that our trades had a disruptive effect. The E-Mini rallied during our trade, suggesting it was not causing the price movement. And the bid/ask spread widened during our trade for less than one second only.”

Implying no judgement on any market participant, the SEC and CFTC said that while trading in the S&P 500 Futures contract was high, there were “many more” sell orders than buy orders between 2.30pm and 2.45pm. However, during this 15 minute period, many active participants withdrew from the market. “Considerable selling pressure at this vulnerable period in time may have contributed to declining prices in the E-Mini S&P 500,” the report said. This slump in price might have influenced selling of other instruments.

Liquidity problems

The SEC and CFTC also said the 5% fall in the price of the S&P 500 Future may have been a consequence of the market turmoil rather than a trigger.

They highlighted a “severe mismatch in liquidity”, as evinced by sharply lower trading prices and possibly exacerbated by the withdrawal of liquidity by electronic market makers and the use of market orders, including automated stop-loss orders.

The regulators said the liquidity mismatch may have been exacerbated by disparate trading conventions among various exchanges, whereby trading was slowed in one venue, while continuing as normal in another.

The CFTC and SEC suggested so-called “stub quotes” may also have influenced the market upheavals. They said stub quotes are designed to technically satisfy a requirement to offer a “two sided quote” but are at such low or high prices that they are not intended to be executed.

The fifth possible cause was the use of market orders. Stop loss market orders and stop loss limit orders might have contributed to market instability and a temporary breakdown in orderly trading, the two US watchdogs said.

Finally, they pointed to exchange-traded funds, the asset class affected most by the price falls of May 6. The report offered four explanations for their influence.

First, an inability by ETF market participants to hedge positions during periods of severe volatility may have contributed to a lack of liquidity in underlying shares.

Second, because ETFs are used by institutional investors as a way to quickly acquire (or eliminate) broad market exposures, this investment strategy may have led to substantial selling pressure on ETFs as the market began to fall steeply.

Third, as in the equity markets, the impact of ETF stop loss market orders, particularly from retail investors, may have triggered declines.

Finally, a severe drain on liquidity at NYSE Arca – the primary listing exchange for most ETFs, may have had a greater impact on market liquidity and trading for ETFs than for the underlying shares.