Unveiling their report into the events of that day, when the Dow Jones Industrial Average fell 1,000 points in minutes, the US regulators said on September 30 that the main trigger had been a mutual fund’s algorithmically executed sale, which occurred on a bearish day in the markets, at a time of reduced liquidity.
The report did not name the firm, though it has been widely reported to be Waddell & Reed Financial. Over the space of about 20 minutes, the firm used an algorithm to sell 75,000 of CME Group’s E-Mini S&P 500 Futures, worth about $4.1bn altogether. The apparent purpose was to hedge a long equity position.
This was the largest net change of position on a single day by any trader in the E-Mini S&P contract this year. Of the two trades in the previous 12 months of the same or larger size, one was by the same fund manager.
However, on the previous occasion it used a combination of manual and algorithmic execution, and made the trades over a five hour period. This time the selling came much faster – and crucially, on what was already a bad day for the markets.
As the regulators put it: “May 6 started as an unusually turbulent day for the markets.” Investors were worried about a European sovereign default and economic problems. By 2.30pm the Dow Jones Industrial Average was down about 2.5%, the CBOE Volatility Index was up 22.5%, the euro was falling and Treasuries were rising.
The regulators noted that by the early afternoon, buy side “liquidity”, meaning resting orders, had fallen from $6bn in the morning to about $2.65bn for the E-Mini S&P futures, while for the SPDR S&P 500 exchange-traded fund, known as Spy, it had fallen from about $275m to $200m. Investors and trading firms, worried by market conditions, were holding back.
Then, at 2.32pm, the market was hit with this large sale of S&P E-Mini futures. The fund manager used an algorithm to execute it whereby its volume of orders was 9% of the total trading volume in the previous minute. The algorithm did not take into account price or time.
Initially, the contracts were acquired by high frequency traders (HFTs) and other intermediaries in the futures market; fundamental futures buyers; and cross-market arbitrageurs, looking to make a profit by buying futures and selling Spy or shares.
The report said HFTs accumulated a net long position of about 3,300 contracts. Then, between 2.41pm and 2.44pm, they “aggressively” sold about 2,000 contracts to reduce their long position.
“At the same time,” the report said, “the 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.”
Noticing the increased volume, the mutual fund’s algorithm then accelerated its sales of S&P contracts, “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 necessarily a reliable indicator of market liquidity.”
Two liquidity crises
What happened next, the report said, is best described in terms of two liquidity crises – one at the broad level in the E-Mini, the other with respect to individual stocks.
Between 2.41 and 2.44, the combined selling pressure from the original seller, the HFTs and other traders drove the price of the S&P 500 futures down about 3%. Cross-market arbitrageurs were buying futures but selling equities, driving Spy down 3%.
The most intense part of the crash in the S&P occurred between 2.45 and 2.46. “HFTs began,” the report said, “to quickly buy and then resell contracts to each other – generating a ‘hot potato’ volume effect as the same positions were rapidly passed back and forth. Between 2.45:13 and 2.45:27, HFTs traded over 27,000 contracts, which accounted for about 49% of the total trading volume, while buying only about 200 additional contracts net.”
During those 15 seconds, the index fell another 1.7%, as orders to buy futures dwindled to $58m – from $6bn at the beginning of the day. “This sudden decline in both price and liquidity may be symptomatic of the notion that prices were moving so fast, fundamental buyers and cross-market arbitrageurs were either unable or unwilling to supply enough buy side liquidity,” the agencies said.
That meant the E-Mini had fallen 5% and and Spy 6% within 4.5 minutes. Crossmarket traders say they were buying futures and selling Spy, baskets of equities or other index products at this time. Resting orders to buy Spy had fallen to about 600,000 shares, a quarter of their level in the morning, by 2.45:28.
Between 2.32 and 2.45, the original seller had shifted about 35,000 E-Mini contracts. All fundamental sellers combined had sold about a net 80,000 contracts, while fundamental buyers had bought about 50,000. Those levels were 13 times and 10 times what they had been in the same period on the three previous days.
CME shuts E-Mini down
At 2.45:28 CME’s Stop Logic Functionality was triggered, causing a five second pause in E-Mini trading. After that, selling pressure was partly alleviated and buying interest increased. Prices stabilised and first the E-Mini, then Spy began to recover.
Nevertheless, the fund manager’s sell algorithm continued to operate, now into a rising market, until 2.51.
It was at 2.45 that the second liquidity crisis began – this time in ordinary shares. This crisis was bigger and slower – though it, too, had mainly blown over by 3pm.
Between 2.40 and 3pm about 2bn shares worth $56bn were traded. More than 98% of those shares were traded at prices within 10% of their 2.40 values. However, that still leaves room for investors to have made substantial losses, if they sold at depressed prices.
And the effects were very uneven. The report said liquidity “completely evaporated” in some securities and ETFs. As a result, trades were made at ludicrous prices such as a penny or $100,000, against so-called ‘stub quotes’ that some market makers had lodged to fulfil continuous quoting obligations, without ever expecting to execute against them.
During those 20 minutes, more than 20,000 orders in over 300 securities were executed at prices more than 60% away from their 2.40 levels. These trades were cancelled by agreement between the exchanges and Finra after the market closed, under rules covering ‘clearly erroneous’ trades. However, many more trades at badly depressed prices were left to stand.
Algos black out
What was going on was a reaction to the shock in the index market. Some firms’ automated trading systems went into automatic shutdowns. Those traders then had to decide what to do. “Participants reported,” the agencies said, “that these assessments included the following factors: whether observed severe price moves could be an artifact of erroneous data; the impact of such moves on risk and position limits; impacts on intraday profit and loss; the potential for trades to be broken, leaving their firms inadvertently long or short on one side of the market; and the ability of their systems to handle the very high volume of trades and orders they were processing that day.
“In addition, 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.”
As a result, some traders widened their quote spreads, others withdrew some of their liquidity, and some stopped bidding altogether. Some fell back to manual trading but could only handle a few securities. Volume rose nearly tenfold.
“HFTs in the equity markets, 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,” the report said. Some continued to trade, others backed away or pulled out.
Many over the counter market makers that normally internalise part of their retail order flow instead routed it straight to the exchanges, where, the report said, it “competed” with other orders for what liquidity there was.
Many lessons to learn
Summarising the lessons learned from the episode, the CFTC and SEC noted:
· 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
· the interaction between automated execution programs and algorithmic trading strategies can quickly erode liquidity and result in disorderly markets
· especially in times of significant volatility, high trading volume is not necessarily a reliable indicator of market liquidity
· cash and derivative markets are highly interconnected, confirming the need for “a harmonised regulatory approach” between CFTC and SEC
· as a result, the two commissions 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
· many market participants employ their own versions of a trading pause, 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
· 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 reestablished
· the SEC, exchanges and Finra therefore introduced circuit breakers for individual securities. This began on June 10 for S&P 500 constituents and on September 10 for Russell 1000 stocks and some ETFs. Trading across US markets will halt for five minutes if the security has had a 10% price change over the preceding five minutes. The circuit breaker programme will run on a pilot basis until December 10
· market participants’ uncertainty about when trades will be broken can affect their trading strategies and willingness to provide liquidity. 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
· the SEC, exchanges and Finra therefore introduced a new, clearer and more objective process for breaking erroneous trades on September 10. It will run on a pilot basis until December 10
· the SEC will consider adopting other mechanisms, such as a limit up/limit down procedure that would prevent trades outside specified parameters, while allowing trading to continue within those parameters. Such a procedure could prevent many anomalous trades and limit the disruptive effect of those that do occur, and may work well in tandem with a trading pause mechanism
· although market data delays do not seem to have been the primary factor in the crash, the actions of market participants can be strongly 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 centres’ data processes, especially those that involve the publication of trades and quotes to the consolidated market data feeds
· the agencies will work with market centres to explore 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
While the report did not introduce any new regulations, a joint statement from CFTC chairman Gary Gensler and SEC chairman Mary Schapiro hinted of possible new rules.
“This report identifies what happened and reaffirms the importance of a number of the actions we have taken since that day,” the chairmen said. “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.”