High frequency traders have been widely blamed for exacerbating the crash, but the report did not satisfy those thirsting for the HFT firms’ blood.

The SEC’s official explanation for the events of May 6 – when 1,000 points were wiped off the Dow Jones Index in 20 minutes – rested on the snowball effects of a single large E-Mini S&P 500 Futures trade by one firm.

The joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues – a group of eight academics and regulators – was convened in the aftermath of the crash.

It has made 14 suggestions, including an extension of temporary solutions designed to alter the way trades are executed and the venues on which they are conducted.

How long is temporary?
The temporary measures brought in after the Flash Crash include circuit breakers, which trigger a pause in the trading of a security and options linked to it, if price moves become too extreme.

The committee proposed keeping the pauses but changing them to a limit up/limit down system. Their scope would be expanded to include “all but the most inactively traded equity securities, ETFs, options and single stock futures”.

The SEC is already considering a limit up/limit down rule for US equity markets. It would put the market into a “limit state” if a stock moved by a set percentage over a rolling five minute period. During the limit state, executions could not take place outside a specified price band. Unlike a pause, this would allow the market to exit the limit state naturally when contra-side liquidity appeared at a price above the limit price.

The committee has yet to decide whether to allow equity options and futures to continue trading during a limit period. Members argued the crash had demonstrated the interconnectedness of the equity and derivatives markets. They said CME’s Stop Logic Functionality, which allows a five second pause in trading, had worked well on May 6, but that in future such a period could be insufficient if a big news event occurred which could trigger a substantial market movement.

The committee stopped short of calling for an overhaul of the five second pause used by US derivatives exchanges, but said they should examine their pre-trade risk safeguards.

Tinkering with HFT
In the aftermath of the crash, US politicians were quick to declare algorithmic traders at fault, and urged regulators to clamp down on the practice. The committee trod a different path, urging HFT firms to show greater responsibility.

In particular, the report highlighted the CFTC’s recent proposal of new rules to specify certain trading and quoting practices as disruptive of fair and equitable trading – notably executing large orders in a disorderly way. The CFTC is also considering outlining specific duties of supervision relating to monitoring automated trading systems to prevent disruptive trading.

The Committee said it “strongly” believed the CFTC should impose supervisory provisions, similar to those set by the SEC, on any FCM sponsoring algorithmic orders to an exchange. Algo trading firms would have to demonstrate they had carefully evaluated how an algorithm would operate in a number of scenarios engendering high market volatility.

Such measures are particularly significant, since one of the triggers for the Flash Crash was the timing of a mutual fund’s algorithmically executed E-Mini S&P 500 Futures sale, which occurred on a bearish day in the markets and at a time of reduced liquidity.

Regulators have not named the firm, though it has been widely reported to be Waddell & Reed Financial. Over about 20 minutes, the firm used an algorithm to sell 75,000 of the futures at CME, worth about $4.1bn, apparently to hedge a long equity position.

Paying for liquidity
Official reports into the day’s events found the crash to be something of a perfect storm, exacerbated by algorithmic trading. A lack of liquidity was cited as the key driver in the collapse.

The committee’s report echoed those findings, but suggested stock exchanges could do more to encourage liquidity in shares.

One method mooted was introducing keener incentives in maker/taker pricing schemes, especially at peak times. Such schemes rebate firms for providing quotes, while those who place orders are charged “taker” access fees.

The committee also said the SEC should look into incentives or rules that would increase a market maker’s responsibilites, for example by making it “regularly” provide quotes that are “reasonably related to the market”.

While the committee was softer on HFT firms than some expected, it did propose that regulators seek ways to make them contribute to the cost of surveillance. .

The CFTC noted schemes in the equity markets which charge HFT players that have high ratios of cancelled trades to actual trades, but it did accept there were several obstacles to introducing similar schemes for derivatives.

“At a minimum, we believe that the participants of those strategies should properly absorb the externalised costs of their activity. While trading is concentrated in the stock index and single stock futures markets, we also believe that the CFTC should evaluate whether a similar fee initiative would be appropriate,” the committee concluded.