May 6, 2010 flash crash
Encyclopedia
The May 6, 2010 Flash Crash also known as The Crash of 2:45, the 2010 Flash Crash or just simply, the Flash Crash, was a United States
stock market crash
on May 6, 2010 in which the Dow Jones Industrial Average plunged about 1000 points—or about nine percent—only to recover those losses within minutes. It was the second largest point swing, 1,010.14 points, and the biggest one-day point decline, 998.5 points, on an intraday basis in Dow Jones Industrial Average
history.
. At 2:42 pm, with the Dow Jones
down more than 300 points for the day, the equity market began to fall rapidly, dropping more than 600 points in 5 minutes for an almost 1000 point loss on the day by 2:47 pm. Twenty minutes later, by 3:07 pm, the market had regained most of the 600 point drop.
(CFTC) issued a joint report dated September 30, 2010 and titled "Findings Regarding the Market Events of May 6, 2010" identifying the sequence of events leading to the Flash Crash.
The joint report "portrayed a market so fragmented and fragile that a single large trade could send stocks into a sudden spiral," and detailed how a large mutual fund firm selling an unusually large number of E-Mini S&P 500 contracts first exhausted available buyers, and then how high-frequency traders (HFT) started aggressively selling, accelerating the effect of the mutual fund's selling and contributing to the sharp price declines that day.
The SEC and CFTC joint report itself says that "May 6 started as an unusually turbulent day for the markets" and that by the early afternoon "broadly negative market sentiment was already affecting an increase in the price volatility of some individual securities." At 2:32 p.m. (EDT), against a "backdrop of unusually high volatility and thinning liquidity" that day, "a large fundamental trader (a mutual fund complex) initiated a sell program to sell a total of 75,000 E-Mini S&P 500 contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position." The report says that this was an unusually large position and that the computer algorithm the trader used to trade the position was set to "target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time."
As the large seller's trades were executed in the futures market, buyers included high-frequency trading
firms - trading firms that specialize in high-speed trading and rarely hold on to any given position for very long - and within minutes these high-frequency trading firms also started aggressively selling the long futures positions they first accumulated mainly from the mutual fund. The Wall Street Journal quoted the joint report, "'HFTs [then] began to quickly buy and then resell contracts to each other—generating a 'hot-potato' volume effect as the same positions were passed rapidly back and forth.'" The combined sales by the large seller and high-frequency firms quickly drove "the E-mini price down 3% in just four minutes."
From the SEC/CFTC report itself:
As prices in the futures market fell, there was a spillover into the equities markets. The computer systems used by most high-frequency trading firms to keep track of market activity decided to pause trading, and those firms then scaled back their trading or withdrew from the markets altogether.
The New York Times wrote the joint report then noted "Automatic computerized traders on the stock market shut down as they detected the sharp rise in buying and selling." As computerized high frequency traders exited the stock market, the resulting lack of liquidity "...caused shares of some prominent companies like Procter & Gamble and Accenture to trade down as low as a penny or as high as $100,000." These extreme prices also resulted from "market internalizers," firms that usually trade with customer orders from their own inventory instead of sending those orders to exchanges, "routing 'most, if not all,' retail orders to the public markets -- a flood of unusual selling pressure that sucked up more dwindling liquidity."
While some firms exited the market, firms that remained in the market exacerbated price declines because they "'escalated their aggressive selling' during the downdraft." High-frequency firms during the crisis, like other firms, were net sellers, contributing to the crash.
The joint report said prices stopped falling when, "At 2:45:28 p.m., trading on the E-Mini was paused for five seconds when the Chicago Mercantile Exchange
('CME') Stop Logic Functionality was triggered in order to prevent a cascade of further price declines. In that short period of time, sell-side pressure in the E-Mini was partly alleviated and buy-side interest increased. When trading resumed at 2:45:33 p.m., prices stabilized and shortly thereafter, the E-Mini began to recover, followed by the SPY." Or as the New York Times reported, "The rout continued until an automatic stabilizer on the futures exchange cut in and paused trading for five seconds, after which the markets recovered."
The joint report noted that after a short while, as market participants had "time to react and verify the integrity of their data and systems, buy-side and sell-side interest returned and an orderly price discovery process began to function," and that by 3:00PM (EDT), most stocks "had reverted back to trading at prices reflecting true consensus values" and the Flash Crash was over.
, a large futures exchange
, stated that, insofar as stock index futures traded on CME Group were concerned, its investigation found no evidence that high-frequency trading played a role, and in fact concluded that automated trading had contributed to market stability during the period of the crash. Others speculate that an intermarket sweep order
may have played a role in triggering the crash.
Other reports have speculated that the event may have been triggered by a single sale of 75,000 E-mini S&P 500 contracts valued at around $4 billion by the Overland Park, Kansas firm Waddell & Reed on the Chicago Mercantile Exchange
.
Others suspect a movement in the U.S. Dollar to Japanese Yen
exchange rate.
issued within 24 hours a rare press release in which it argued against the SEC-CFTC explanation:
Dr. David Leinweber, Co-founder and Director of the Center for Innovative Financial Technology at Lawrence Berkeley National Laboratory
, was invited by the Journal of Portfolio Management
to write an editorial, in which he openly criticized the government's technological capabilities and inability to study today's markets.
indexed, peer-reviewed scientific journal. One hour before its collapse, the stock market registered the highest reading of "order flow toxicity" in recent history. The authors of this paper apply widely accepted Market microstructure
models to understand the behavior of prices in the minutes and hours prior to the crash. According to this paper, "order flow toxicity" can be measured as the probability that informed traders (e.g., hedge funds) adversely select
uninformed traders (e.g., Market maker
s). For that purpose, they develop the VPIN Flow Toxicity metric, which delivers a real-time estimate of the conditions under which liquidity is being provided. If the order flow becomes too toxic, market makers are forced out of the market. As they withdraw, liquidity disappears, which increases even more the concentration of toxic flow in the overall volume, which triggers a Feedback mechanism that forces even more market makers out. This cascading effect has caused hundreds of liquidity-induced crashes in past, the flash crash being one (major) example of it. One hour before the flash crash, order flow toxicity was the highest in recent history.
Note that the source of increasing "order flow toxicity" on May 6, 2010 is not determined in this paper or captured in the VPIN metric. Whether a dominant source of toxic order flow on May 6, 2010 was from firms representing public investors or whether a dominant source was intermediary or other proprietary traders could have a significant effect on regulatory proposals put forward to prevent another Flash Crash.
According to Bloomberg, the VPIN Flow Toxicity metric is the subject of a pending patent application filed by renowned Economics Professors Maureen O'Hara
(Cornell University
), David Easley
(Cornell University
) in collaboration with Tudor Investment Corporation, a large hedge fund.
This theory is consistent with the anecdotal evidence reported by the joint SEC-CFTC study on the events of May 6, 2010. An independent study carried out by the Lawrence Berkeley National Laboratory
's CIFT on this line of research concluded:
The Chief Economist of the Commodity Futures Trading Commission
and several academic economists published a working paper
containing a review and empirical analysis of trade data from the Flash Crash. The authors examined the characteristics and activities of buyers and sellers in the Flash Crash and determined that a large seller, a mutual fund firm, exhausted available fundamental buyers and then triggered a cascade of selling by intermediaries, particularly high-frequency trading
firms. Like the SEC/CFTC report described earlier, the authors call this cascade of selling "hot potato trading," as high frequency firms rapidly acquired and then liquidated positions among themselves at steadily declining prices.
The authors conclude:
, CenterPoint Energy
and Exelon
; while other stocks, including Sotheby's
, Apple, and Hewlett-Packard
, increased in value to over $100,000 in price. Procter & Gamble
in particular dropped nearly 37% before rebounding, within minutes, back to near its original levels. The drop in P&G was broadcast live on CNBC
at the time, with commentator Jim Cramer declaring live, "That is not a real price. Just go buy Procter & Gamble. When I looked at it, it was at 61, I’m not that interested in it. It’s at 47? Well, that’s a different security entirely."
released their timeline of the anomalies during U.S. Congressional House Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises hearings on the flash crash. NASDAQ's timeline indicates that NYSE Arca
may have played an early role and that the Chicago Board Options Exchange
sent a message saying that NYSE Arca was "out of NBBO". The Chicago Board Options Exchange, NASDAQ, NASDAQ OMX BX, and BATS Exchange all declared SELF HELP against NYSE Arca.
S.E.C. Chairwoman Mary Schapiro testified that "stub quotes" may have played a role in certain stocks that traded for 1 cent a share.
s, also known as circuit breakers, will be tested during a six-month trial period ending on December 10, 2010. These circuit breakers would halt trading for five minutes on any S&P 500
stock that rises or falls more than 10 percent in a five minute period. The circuit breakers will only be installed to the 404 NYSE listed S&P 500 stocks. The first circuit breakers will be installed to only 5 of the S&P 500 companies on Friday June 11, to experiment with the circuit breakers. The 5 stocks are EOG Resources, Genuine Parts, Harley Davidson, Ryder System, and Zimmer Holdings. By Monday June 14, 44 had them. By Tuesday June 15, the number had grown to 223, and by Wednesday June 16, all 404 companies had circuit breakers installed. On June 16, 2010, trading in the Washington Post Company
's shares were halted for five minutes after it became the first stock to trigger the new circuit breakers. Three erroneous NYSE Arca
trades were said to have been the cause of the share price jump.
As of September 10, the SEC approved new rules submitted by the national securities exchanges and the Financial Industry Regulatory Authority
(FINRA) to expand the circuit breaker program to include all stocks in the Russell 1000 Index and certain exchange-traded funds. The SEC also approved new exchange and FINRA rules that clarify the process for breaking erroneous trades. A list of the securities included in the Russell 1000 Index, which was rebalanced on June 25, is available on the Russell website. The list of exchange-traded products included in the pilot is available on the SEC's website. The SEC anticipates that the exchanges and FINRA will begin implementing the expanded circuit breaker program early next week. The erroneous trade rules were developed in response to the market disruption of May 6. The rules will make it clearer when — and at what prices — trades will be broken by the exchanges and FINRA. As with the circuit breaker program, these rules will be in effect on a pilot basis through Dec. 10, 2010.
For stocks that are subject to the circuit breaker program, trades will be broken at specified levels depending on the stock price:
Where circuit breakers are not applicable, the exchanges and FINRA will break trades at specified levels for events involving multiple stocks depending on how many stocks are involved:
On May 6, the markets only broke trades that were more than 60 percent away from the reference price in a process that was not transparent to market participants. A list of 'winners' and 'losers' created by this arbitrary measure has never been made public. By establishing clear and transparent standards for breaking erroneous trades, the new rules should help provide certainty in advance as to which trades will be broken, and allow market participants to better manage their risks.
published an op-ed in the New York Times on the one year anniversary of the Flash Crash, sharply critical of what they perceive to be the SEC's apparent lack of action to prevent a recurrence.
High-frequency traders move away from the stock market as there has been lower volatility and volume. The combined average daily trading volume in the New York Stock Exchange and Nasdaq Stock Market in the first four months of 2011 fell 15% from 2010, to an average of 6.3 billion shares a day. Trading activities has been declining throughout 2011, with April's daily average of 5.8 billion shares marks the lowest month since May 2008. Decrease of sharp movements in stock prices which were frequent during the period from 2008 to the first half of 2010, can be seen in a decline in the Chicago Board Options Exchange volatility index, the VIX, which fell to its lowest level in April 2011 since July 2007.
The recent volumes of trading activity, to some degree, are regarded as more natural levels than during the financial crisis and its aftermath. Some described those lofty levels of trading activity were never an accurate picture of demand among investors. It was a reflection of computer-driven traders passing securities back and forth between day-trading hedge funds. The flash crash exposed this phantom liquidity. High-frequency trading firms are increasingly active in markets like futures and currencies, where volatility remains high.
Trades by high-frequency traders account for 28% of the total volume in the futures markets, which include currencies and commodities, an increase from 22% in 2009.
However, the growth of computerized and high-frequency trading in commodities and currencies has coincided with a series of "flash crashes" in those markets. The role of human market makers, who can match buyers and sellers and provide liquidity to the market, is now more and more played by computer programs. If those program traders pull back from the market, then big "buy" or "sell" orders can lead to sudden, big swings. It increases the probability of surprise distortions same as the equity markets, according to a professional investor. In February 2011, the sugar market took a dive of 6% in just one second. On March 1, Cocoa-futures prices dropped 13% in less than a minute on the IntercontinentalExchange. Cocoa plunged $450 to a low of $3,217 a metric ton before rebounding quickly. The U.S. dollar tumbled against the yen on March 16, falling 5% in minutes, one of its biggest moves ever. According to a former cocoa trader: ' "The electronic platform is too fast; it doesn't slow things down" like humans would. '
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
stock market crash
Stock market crash
A stock market crash is a sudden dramatic decline of stock prices across a significant cross-section of a stock market, resulting in a significant loss of paper wealth. Crashes are driven by panic as much as by underlying economic factors...
on May 6, 2010 in which the Dow Jones Industrial Average plunged about 1000 points—or about nine percent—only to recover those losses within minutes. It was the second largest point swing, 1,010.14 points, and the biggest one-day point decline, 998.5 points, on an intraday basis in Dow Jones Industrial Average
Dow Jones Industrial Average
The Dow Jones Industrial Average , also called the Industrial Average, the Dow Jones, the Dow 30, or simply the Dow, is a stock market index, and one of several indices created by Wall Street Journal editor and Dow Jones & Company co-founder Charles Dow...
history.
Background
On May 6, US stock markets opened down and trended down most of the day on worries about the debt crisis in Greece2010 European sovereign debt crisis
From late 2009, fears of a sovereign debt crisis developed among investors concerning some European states, intensifying in early 2010 and thereafter.....
. At 2:42 pm, with the Dow Jones
Dow Jones Industrial Average
The Dow Jones Industrial Average , also called the Industrial Average, the Dow Jones, the Dow 30, or simply the Dow, is a stock market index, and one of several indices created by Wall Street Journal editor and Dow Jones & Company co-founder Charles Dow...
down more than 300 points for the day, the equity market began to fall rapidly, dropping more than 600 points in 5 minutes for an almost 1000 point loss on the day by 2:47 pm. Twenty minutes later, by 3:07 pm, the market had regained most of the 600 point drop.
SEC/CFTC Report on May 6, 2010
After almost five months of investigations led by Gregg E. Berman, the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading CommissionCommodity Futures Trading Commission
The U.S. Commodity Futures Trading Commission is an independent agency of the United States government that regulates futures and option markets....
(CFTC) issued a joint report dated September 30, 2010 and titled "Findings Regarding the Market Events of May 6, 2010" identifying the sequence of events leading to the Flash Crash.
The joint report "portrayed a market so fragmented and fragile that a single large trade could send stocks into a sudden spiral," and detailed how a large mutual fund firm selling an unusually large number of E-Mini S&P 500 contracts first exhausted available buyers, and then how high-frequency traders (HFT) started aggressively selling, accelerating the effect of the mutual fund's selling and contributing to the sharp price declines that day.
The SEC and CFTC joint report itself says that "May 6 started as an unusually turbulent day for the markets" and that by the early afternoon "broadly negative market sentiment was already affecting an increase in the price volatility of some individual securities." At 2:32 p.m. (EDT), against a "backdrop of unusually high volatility and thinning liquidity" that day, "a large fundamental trader (a mutual fund complex) initiated a sell program to sell a total of 75,000 E-Mini S&P 500 contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position." The report says that this was an unusually large position and that the computer algorithm the trader used to trade the position was set to "target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time."
As the large seller's trades were executed in the futures market, buyers included high-frequency trading
High-frequency trading
High-frequency trading is the use of sophisticated technological tools to trade securities like stocks or options, and is typically characterized by several distinguishing features:...
firms - trading firms that specialize in high-speed trading and rarely hold on to any given position for very long - and within minutes these high-frequency trading firms also started aggressively selling the long futures positions they first accumulated mainly from the mutual fund. The Wall Street Journal quoted the joint report, "'HFTs [then] began to quickly buy and then resell contracts to each other—generating a 'hot-potato' volume effect as the same positions were passed rapidly back and forth.'" The combined sales by the large seller and high-frequency firms quickly drove "the E-mini price down 3% in just four minutes."
From the SEC/CFTC report itself:
- The combined selling pressure from the Sell Algorithm, HFTs and other traders drove the price of the E-Mini S&P 500 down approximately 3% in just four minutes from the beginning of 2:41 p.m. through the end of 2:44 p.m. During this same time cross-market arbitrageurs who did buy the E-Mini S&P 500, simultaneously sold equivalent amounts in the equities markets, driving the price of SPY (an exchange-traded fundExchange-traded fundAn exchange-traded fund is an investment fund traded on stock exchanges, much like stocks. An ETF holds assets such as stocks, commodities, or bonds, and trades close to its net asset value over the course of the trading day. Most ETFs track an index, such as the S&P 500 or MSCI EAFE...
which represents the S&P 500S&P 500The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
index) also down approximately 3%.
- Still lacking sufficient demand from fundamental buyers or cross-market arbitrageurs, HFTs began 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 percent of the total trading volume, while buying only about 200 additional contracts net.
As prices in the futures market fell, there was a spillover into the equities markets. The computer systems used by most high-frequency trading firms to keep track of market activity decided to pause trading, and those firms then scaled back their trading or withdrew from the markets altogether.
The New York Times wrote the joint report then noted "Automatic computerized traders on the stock market shut down as they detected the sharp rise in buying and selling." As computerized high frequency traders exited the stock market, the resulting lack of liquidity "...caused shares of some prominent companies like Procter & Gamble and Accenture to trade down as low as a penny or as high as $100,000." These extreme prices also resulted from "market internalizers," firms that usually trade with customer orders from their own inventory instead of sending those orders to exchanges, "routing 'most, if not all,' retail orders to the public markets -- a flood of unusual selling pressure that sucked up more dwindling liquidity."
While some firms exited the market, firms that remained in the market exacerbated price declines because they "'escalated their aggressive selling' during the downdraft." High-frequency firms during the crisis, like other firms, were net sellers, contributing to the crash.
The joint report said prices stopped falling when, "At 2:45:28 p.m., trading on the E-Mini was paused for five seconds when the Chicago Mercantile Exchange
Chicago Mercantile Exchange
The Chicago Mercantile Exchange is an American financial and commodity derivative exchange based in Chicago. The CME was founded in 1898 as the Chicago Butter and Egg Board. Originally, the exchange was a non-profit organization...
('CME') Stop Logic Functionality was triggered in order to prevent a cascade of further price declines. In that short period of time, sell-side pressure in the E-Mini was partly alleviated and buy-side interest increased. When trading resumed at 2:45:33 p.m., prices stabilized and shortly thereafter, the E-Mini began to recover, followed by the SPY." Or as the New York Times reported, "The rout continued until an automatic stabilizer on the futures exchange cut in and paused trading for five seconds, after which the markets recovered."
The joint report noted that after a short while, as market participants had "time to react and verify the integrity of their data and systems, buy-side and sell-side interest returned and an orderly price discovery process began to function," and that by 3:00PM (EDT), most stocks "had reverted back to trading at prices reflecting true consensus values" and the Flash Crash was over.
Early theories
CME GroupCME Group
The CME Group bases prices for US gasoline on Brent Crude rather than West Texas Intermediate Crude , which many believe is responsible for artificially high gas prices for US consumers...
, a large futures exchange
Futures exchange
A futures exchange or futures market is a central financial exchange where people can trade standardized futures contracts; that is, a contract to buy specific quantities of a commodity or financial instrument at a specified price with delivery set at a specified time in the future. These types of...
, stated that, insofar as stock index futures traded on CME Group were concerned, its investigation found no evidence that high-frequency trading played a role, and in fact concluded that automated trading had contributed to market stability during the period of the crash. Others speculate that an intermarket sweep order
Intermarket sweep order
Intermarket sweep orders are limit orders that require they be executed in one specific market center even if another market center is publishing a better quote, disobeying the order-protection rule. They are typically used by institutional algorithmic investors and not by individual investors...
may have played a role in triggering the crash.
- The fat-finger theory: Disproved. In the immediate aftermath of the plunge, several reports indicated that the event may have been triggered by a fat-finger trade, an inadvertent large "sell order" for Procter & GambleProcter & GambleProcter & Gamble is a Fortune 500 American multinational corporation headquartered in downtown Cincinnati, Ohio and manufactures a wide range of consumer goods....
stock, inciting massive algorithmic tradingAlgorithmic tradingIn electronic financial markets, algorithmic trading or automated trading, also known as algo trading, black-box trading or robo trading, is the use of electronic platforms for entering trading orders with an algorithm deciding on aspects of the order such as the timing, price, or quantity of the...
orders to dump the stock; however, this theory was quickly disproved after it was determined that Procter and Gamble's decline occurred after a significant decline in the E-mini S&P 500 Futures contracts. The "fat-finger trade" hypothesis was also disproved when it was determined that existing CME GroupCME GroupThe CME Group bases prices for US gasoline on Brent Crude rather than West Texas Intermediate Crude , which many believe is responsible for artificially high gas prices for US consumers...
and ICE safeguards would have prevented such an error. Currently, the fat-finger theory is not considered credible. - Impact of High Frequency traders: Regulators found HFT's exacerbated price declines. As noted above, regulators found that high frequency traders exacerbated price declines. Regulators determined that high frequency traders sold aggressively to eliminate their positions and withdrew from the markets in the face of uncertainty. A July, 2011 report by the International Organization of Securities CommissionsInternational Organization of Securities CommissionsThe International Organization of Securities Commissions is an association of organisations that regulate the world’s securities and futures markets....
(IOSCO), an international body of securities regulators, concluded that while "algorithms and HFT technology have been used by market participants to manage their trading and risk, their usage was also clearly a contributing factor in the flash crash event of May 6, 2010." Other theories postulate that the actions of high frequency traders (HFTs)High-frequency tradingHigh-frequency trading is the use of sophisticated technological tools to trade securities like stocks or options, and is typically characterized by several distinguishing features:...
was the underlying cause of the flash crash. One hypothesis, based on the analysis of bid-offer data by Nanex, Llc., is that HFTs send non-executable orders (orders that are outside the bid-offer spreadBid-offer spreadThe bid–offer spread for securities is the difference between the prices quoted for an immediate sale and an immediate purchase...
) to exchanges in batches. Though the purpose of these orders is unknown, some experts speculate that their purpose is to increase noise, clog exchanges, and outwit competitors. However, other experts believe that deliberate market manipulationMarket manipulationMarket manipulation describes a deliberate attempt to interfere with the free and fair operation of the market and create artificial, false or misleading appearances with respect to the price of, or market for, a security, commodity or currency...
is unlikely because there is no practical way in which the HFTs can profit from these orders, and it is more likely that these orders are designed to test latency times and to detect early price trends. Whatever the reasons behind the possible existence of these orders, this theory postulates that they exacerbated the crash by overloading the exchanges on May 6. On September 3, 2010 the regulators probing the crash concluded: "that quote-stuffing – placing and then almost immediately cancelling large numbers of rapid-fire orders to buy or sell stocks – was not a “major factor” in the turmoil." Some have put forth the theory High-frequency tradingHigh-frequency tradingHigh-frequency trading is the use of sophisticated technological tools to trade securities like stocks or options, and is typically characterized by several distinguishing features:...
actually have been a major factor in minimizing and reversing the flash crash. - Large directional bets: Regulators say a large E-Mini S&P 500 seller set off a chain of events triggering the Flash Crash, but did not identify the firm. Earlier, some investigators suggested that a large purchase of put options on the S&P 500 indexS&P 500The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
by the hedge fundHedge fundA hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...
Universa Investments shortly before the crash may have been among the primary causes.
Other reports have speculated that the event may have been triggered by a single sale of 75,000 E-mini S&P 500 contracts valued at around $4 billion by the Overland Park, Kansas firm Waddell & Reed on the Chicago Mercantile Exchange
Chicago Mercantile Exchange
The Chicago Mercantile Exchange is an American financial and commodity derivative exchange based in Chicago. The CME was founded in 1898 as the Chicago Butter and Egg Board. Originally, the exchange was a non-profit organization...
.
Others suspect a movement in the U.S. Dollar to Japanese Yen
Japanese yen
The is the official currency of Japan. It is the third most traded currency in the foreign exchange market after the United States dollar and the euro. It is also widely used as a reserve currency after the U.S. dollar, the euro and the pound sterling...
exchange rate.
- Changes in market structure: Some market structure experts speculate that, whatever the underlying causes, equity markets are vulnerable to these sort of events because of decentralization of trading.
- Technical glitches: An analysis of trading on the exchanges during the moments immediately prior to the flash crash reveals technical glitches in the reporting of prices on the NYSENew York Stock ExchangeThe New York Stock Exchange is a stock exchange located at 11 Wall Street in Lower Manhattan, New York City, USA. It is by far the world's largest stock exchange by market capitalization of its listed companies at 13.39 trillion as of Dec 2010...
and various ATSsAlternative Trading SystemsAlternative Trading Systems , are United States Securities and Exchange Commission approved non-exchange trading venues specifically designed to match buyers and sellers to find counterparties for transactions, instead of trading large blocks of shares on the normal exchange, a practice that can...
that might have contributed to the drying up of liquidityMarket liquidityIn business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...
. According to this theory, technical problems at the NYSE led to delays as long as five minutes in NYSE quotes being reported on the Consolidated Quotation SystemConsolidated Quotation SystemThe Consolidated Quotation System is the electronic service that provides quotation information for stock traded on the American Stock Exchange, New York Stock Exchange, and other regional stock exchanges in the United States and also includes issues traded by FINRA member firms in the third market...
(CQS) with time stamps indicating that the quotes were current. However, some market participants (those with access to NYSE's own quote reporting system, OpenBook) could see both correct current NYSE quotes, as well as the delayed but apparently current CQS quotes. At the same time, there were errors in the prices of some stocks (Apple Computers, Sothebys, and some ETFs). Confused and uncertain about prices, many market participants attempted to drop out of the market by posting stub quotes (very low bids and very high offers) and, at the same time, many high-frequency trading algorithms attempted to exit the market with market orders (which were executed at the stub quotes) leading to a domino effect that resulted in the flash crash plunge.
Criticism to the SEC-CFTC report
A few hours after the release of the 104 pages SEC-CFTC report, a number of critics stated that blaming a single order (from Waddell & Reed) for triggering the event was disingenuous. Most prominent of all, the CMEChicago Mercantile Exchange
The Chicago Mercantile Exchange is an American financial and commodity derivative exchange based in Chicago. The CME was founded in 1898 as the Chicago Butter and Egg Board. Originally, the exchange was a non-profit organization...
issued within 24 hours a rare press release in which it argued against the SEC-CFTC explanation:
| According to the CME, |
Dr. David Leinweber, Co-founder and Director of the Center for Innovative Financial Technology at Lawrence Berkeley National Laboratory
Lawrence Berkeley National Laboratory
The Lawrence Berkeley National Laboratory , is a U.S. Department of Energy national laboratory conducting unclassified scientific research. It is located on the grounds of the University of California, Berkeley, in the Berkeley Hills above the central campus...
, was invited by the Journal of Portfolio Management
Journal of Portfolio Management
The Journal of Portfolio Management is a quarterly academic journal covering asset allocation, performance measurement, market trends, risk management, and portfolio optimization. The journal was established in 1974 by Peter L. Bernstein. The current editor-in-chief is Frank J...
to write an editorial, in which he openly criticized the government's technological capabilities and inability to study today's markets.
| Dr. Leinweber wrote, |
Academic research
As of July, 2011, only one theory on the causes of the flash crash has yet been published by a Journal Citation ReportsJournal Citation Reports
Journal Citation Reports is an annual publication by the Healthcare & Science division of Thomson Reuters. It has been integrated with the Web of Knowledge, by Thomson Reuters, and is accessed from the Web of Science to JCR Web. It provides information about academic journals in the sciences and...
indexed, peer-reviewed scientific journal. One hour before its collapse, the stock market registered the highest reading of "order flow toxicity" in recent history. The authors of this paper apply widely accepted Market microstructure
Market microstructure
Market microstructure is a branch of finance concerned with the details of how exchange occurs in markets. While the theory of market microstructure applies to the exchange of real or financial assets, more evidence is available on the microstructure of financial markets due to the availability of...
models to understand the behavior of prices in the minutes and hours prior to the crash. According to this paper, "order flow toxicity" can be measured as the probability that informed traders (e.g., hedge funds) adversely select
Adverse selection
Adverse selection, anti-selection, or negative selection is a term used in economics, insurance, statistics, and risk management. It refers to a market process in which "bad" results occur when buyers and sellers have asymmetric information : the "bad" products or services are more likely to be...
uninformed traders (e.g., Market maker
Market maker
A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on the bid-offer spread, or turn. From a market microstructure theory standpoint, market makers are net sellers of an option to be...
s). For that purpose, they develop the VPIN Flow Toxicity metric, which delivers a real-time estimate of the conditions under which liquidity is being provided. If the order flow becomes too toxic, market makers are forced out of the market. As they withdraw, liquidity disappears, which increases even more the concentration of toxic flow in the overall volume, which triggers a Feedback mechanism that forces even more market makers out. This cascading effect has caused hundreds of liquidity-induced crashes in past, the flash crash being one (major) example of it. One hour before the flash crash, order flow toxicity was the highest in recent history.
Note that the source of increasing "order flow toxicity" on May 6, 2010 is not determined in this paper or captured in the VPIN metric. Whether a dominant source of toxic order flow on May 6, 2010 was from firms representing public investors or whether a dominant source was intermediary or other proprietary traders could have a significant effect on regulatory proposals put forward to prevent another Flash Crash.
According to Bloomberg, the VPIN Flow Toxicity metric is the subject of a pending patent application filed by renowned Economics Professors Maureen O'Hara
Maureen O'Hara (professor)
Maureen Patricia O'Hara is an American financial economist. O'Hara is the Robert W. Purcell Professor of Management, a professor of finance, and Acting Director in Graduate Studies at the Samuel Curtis Johnson Graduate School of Management at Cornell University...
(Cornell University
Cornell University
Cornell University is an Ivy League university located in Ithaca, New York, United States. It is a private land-grant university, receiving annual funding from the State of New York for certain educational missions...
), David Easley
David Easley
David Alan Easley is an American economist. Easley is the Henry Scarborough Professor of Social Science and the Donald C. Opatrny'74 Chair of the Department of Economics at Cornell University....
(Cornell University
Cornell University
Cornell University is an Ivy League university located in Ithaca, New York, United States. It is a private land-grant university, receiving annual funding from the State of New York for certain educational missions...
) in collaboration with Tudor Investment Corporation, a large hedge fund.
This theory is consistent with the anecdotal evidence reported by the joint SEC-CFTC study on the events of May 6, 2010. An independent study carried out by the Lawrence Berkeley National Laboratory
Lawrence Berkeley National Laboratory
The Lawrence Berkeley National Laboratory , is a U.S. Department of Energy national laboratory conducting unclassified scientific research. It is located on the grounds of the University of California, Berkeley, in the Berkeley Hills above the central campus...
's CIFT on this line of research concluded:
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- This [VPIN] is the strongest early warning signal known to us at this time.
The Chief Economist of the Commodity Futures Trading Commission
Commodity Futures Trading Commission
The U.S. Commodity Futures Trading Commission is an independent agency of the United States government that regulates futures and option markets....
and several academic economists published a working paper
Working paper
A working paper or work paper or workpaper may refer to:*A preliminary scientific or technical paper. Often, authors will release working papers to share ideas about a topic or to elicit feedback before submitting to a peer reviewed conference or academic journal.* Sometimes the term working paper...
containing a review and empirical analysis of trade data from the Flash Crash. The authors examined the characteristics and activities of buyers and sellers in the Flash Crash and determined that a large seller, a mutual fund firm, exhausted available fundamental buyers and then triggered a cascade of selling by intermediaries, particularly high-frequency trading
High-frequency trading
High-frequency trading is the use of sophisticated technological tools to trade securities like stocks or options, and is typically characterized by several distinguishing features:...
firms. Like the SEC/CFTC report described earlier, the authors call this cascade of selling "hot potato trading," as high frequency firms rapidly acquired and then liquidated positions among themselves at steadily declining prices.
The authors conclude:
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- Based on our analysis, we believe that High Frequency Traders exhibit trading patterns inconsistent with the traditional definition of market making. Specifically, High Frequency Traders aggressively trade in the direction of price changes. This activity comprises a large percentage of total trading volume, but does not result in a significant accumulation of inventory. As a result, whether under normal market conditions or during periods of high volatility, High Frequency Traders are not willing to accumulate large positions or absorb large losses. Moreover, their contribution to higher trading volumes may be mistaken for liquidity by Fundamental Traders. Finally, when rebalancing their positions, High Frequency Traders may compete for liquidity and amplify price volatility.
-
- Consequently, we believe, that irrespective of technology, markets can become fragile when imbalances arise as a result of large traders seeking to buy or sell quantities larger than intermediaries are willing to temporarily hold, and simultaneously long-term suppliers of liquidity are not forthcoming even if significant price concessions are offered.
Stock market reaction
A stock market anomaly, the major market indexes dropped by over 9% (including a roughly 7% decline in a roughly 15 minute span at approximately 2:45 pm eastern time on May 6, 2010) before a partial rebound. Temporarily, $1 trillion in market value disappeared. While stock markets do crash, immediate rebounds are unprecedented. The stocks of eight major companies in the S&P 500 fell to one cent per share for a short time, including AccentureAccenture
Accenture plc is a global management consulting, technology services and outsourcing company headquartered in Dublin, Republic of Ireland. It is the largest consulting firm in the world and is a Fortune Global 500 company. As of September 2011, the company had more than 236,000 employees across...
, CenterPoint Energy
CenterPoint Energy
CenterPoint Energy is a Fortune 500 electric and natural gas utility serving several markets in the U.S. states of Arkansas, Louisiana, Minnesota, Mississippi, Oklahoma, and Texas. It was formerly known as Reliant Energy , NorAm Energy, Houston Industries, and HL&P...
and Exelon
Exelon
Exelon Corporation is an electricity generating and distributing company headquartered in the Chase Tower in the Chicago Loop area of Chicago. It was created in October, 2000 by the merger of PECO Energy Company and Unicom, of Philadelphia and Chicago respectively. Unicom owned Commonwealth Edison...
; while other stocks, including Sotheby's
Sotheby's
Sotheby's is the world's fourth oldest auction house in continuous operation.-History:The oldest auction house in operation is the Stockholms Auktionsverk founded in 1674, the second oldest is Göteborgs Auktionsverk founded in 1681 and third oldest being founded in 1731, all Swedish...
, Apple, and Hewlett-Packard
Hewlett-Packard
Hewlett-Packard Company or HP is an American multinational information technology corporation headquartered in Palo Alto, California, USA that provides products, technologies, softwares, solutions and services to consumers, small- and medium-sized businesses and large enterprises, including...
, increased in value to over $100,000 in price. Procter & Gamble
Procter & Gamble
Procter & Gamble is a Fortune 500 American multinational corporation headquartered in downtown Cincinnati, Ohio and manufactures a wide range of consumer goods....
in particular dropped nearly 37% before rebounding, within minutes, back to near its original levels. The drop in P&G was broadcast live on CNBC
CNBC
CNBC is a satellite and cable television business news channel in the U.S., owned and operated by NBCUniversal. The network and its international spinoffs cover business headlines and provide live coverage of financial markets. The combined reach of CNBC and its siblings is 390 million viewers...
at the time, with commentator Jim Cramer declaring live, "That is not a real price. Just go buy Procter & Gamble. When I looked at it, it was at 61, I’m not that interested in it. It’s at 47? Well, that’s a different security entirely."
Congressional hearings
The NASDAQNASDAQ
The NASDAQ Stock Market, also known as the NASDAQ, is an American stock exchange. "NASDAQ" originally stood for "National Association of Securities Dealers Automated Quotations". It is the second-largest stock exchange by market capitalization in the world, after the New York Stock Exchange. As of...
released their timeline of the anomalies during U.S. Congressional House Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises hearings on the flash crash. NASDAQ's timeline indicates that NYSE Arca
NYSE Arca
NYSE Arca, previously known as ArcaEx, an abbreviation of Archipelago Exchange, is a securities exchange on which both stocks and options are traded...
may have played an early role and that the Chicago Board Options Exchange
Chicago Board Options Exchange
The Chicago Board Options Exchange , located at 400 South LaSalle Street in Chicago, is the largest U.S. options exchange with annual trading volume that hovered around one billion contracts at the end of 2007...
sent a message saying that NYSE Arca was "out of NBBO". The Chicago Board Options Exchange, NASDAQ, NASDAQ OMX BX, and BATS Exchange all declared SELF HELP against NYSE Arca.
S.E.C. Chairwoman Mary Schapiro testified that "stub quotes" may have played a role in certain stocks that traded for 1 cent a share.
| According to Schapiro, |
Circuit breakers
Officials announced that new trading curbTrading curb
A trading curb, also known as a circuit breaker, is a point at which a stock market will stop trading for a period of time in response to substantial drops in value.-Circuit breakers:...
s, also known as circuit breakers, will be tested during a six-month trial period ending on December 10, 2010. These circuit breakers would halt trading for five minutes on any S&P 500
S&P 500
The S&P 500 is a free-float capitalization-weighted index published since 1957 of the prices of 500 large-cap common stocks actively traded in the United States. The stocks included in the S&P 500 are those of large publicly held companies that trade on either of the two largest American stock...
stock that rises or falls more than 10 percent in a five minute period. The circuit breakers will only be installed to the 404 NYSE listed S&P 500 stocks. The first circuit breakers will be installed to only 5 of the S&P 500 companies on Friday June 11, to experiment with the circuit breakers. The 5 stocks are EOG Resources, Genuine Parts, Harley Davidson, Ryder System, and Zimmer Holdings. By Monday June 14, 44 had them. By Tuesday June 15, the number had grown to 223, and by Wednesday June 16, all 404 companies had circuit breakers installed. On June 16, 2010, trading in the Washington Post Company
Washington Post Company
The Washington Post Company is an American education and media company, best known for owning the newspaper for which it is named, The Washington Post. The Company also owns Kaplan, Inc., a leading international provider of educational and career services for individuals, schools and businesses...
's shares were halted for five minutes after it became the first stock to trigger the new circuit breakers. Three erroneous NYSE Arca
NYSE Arca
NYSE Arca, previously known as ArcaEx, an abbreviation of Archipelago Exchange, is a securities exchange on which both stocks and options are traded...
trades were said to have been the cause of the share price jump.
As of September 10, the SEC approved new rules submitted by the national securities exchanges and the Financial Industry Regulatory Authority
Financial Industry Regulatory Authority
In the United States, the Financial Industry Regulatory Authority, Inc., or FINRA, is a private corporation that acts as a self-regulatory organization . FINRA is the successor to the National Association of Securities Dealers, Inc. ...
(FINRA) to expand the circuit breaker program to include all stocks in the Russell 1000 Index and certain exchange-traded funds. The SEC also approved new exchange and FINRA rules that clarify the process for breaking erroneous trades. A list of the securities included in the Russell 1000 Index, which was rebalanced on June 25, is available on the Russell website. The list of exchange-traded products included in the pilot is available on the SEC's website. The SEC anticipates that the exchanges and FINRA will begin implementing the expanded circuit breaker program early next week. The erroneous trade rules were developed in response to the market disruption of May 6. The rules will make it clearer when — and at what prices — trades will be broken by the exchanges and FINRA. As with the circuit breaker program, these rules will be in effect on a pilot basis through Dec. 10, 2010.
For stocks that are subject to the circuit breaker program, trades will be broken at specified levels depending on the stock price:
- For stocks priced $25 or less, trades will be broken if the trades are at least 10 percent away from the circuit breaker trigger price.
- For stocks priced more than $25 to $50, trades will be broken if they are 5 percent away from the circuit breaker trigger price.
- For stocks priced more than $50, the trades will be broken if they are 3 percent away from the circuit breaker trigger price.
Where circuit breakers are not applicable, the exchanges and FINRA will break trades at specified levels for events involving multiple stocks depending on how many stocks are involved:
- For events involving between five and 20 stocks, trades will be broken that are at least 10 percent away from the "reference price," typically the last sale before pricing was disrupted.
- For events involving more than 20 stocks, trades will be broken that are at least 30 percent away from the reference price.
On May 6, the markets only broke trades that were more than 60 percent away from the reference price in a process that was not transparent to market participants. A list of 'winners' and 'losers' created by this arbitrary measure has never been made public. By establishing clear and transparent standards for breaking erroneous trades, the new rules should help provide certainty in advance as to which trades will be broken, and allow market participants to better manage their risks.
One year later
In an article that appeared on the Wall Street Journal on the eve of the anniversary of the 2010 'flash crash', it reported high-frequency traders are now less active in the stock market. In a separate article in the journal, it described trades by high-frequency traders has decreased to 53% of stock-market trading volume, from 61% in 2009. Former Delaware senator Edward E. Kaufman and Michigan senator Carl LevinCarl Levin
Carl Milton Levin is a Jewish-American United States Senator from Michigan, serving since 1979. He is the Chairman of the Senate Committee on Armed Services. He is a member of the Democratic Party....
published an op-ed in the New York Times on the one year anniversary of the Flash Crash, sharply critical of what they perceive to be the SEC's apparent lack of action to prevent a recurrence.
High-frequency traders move away from the stock market as there has been lower volatility and volume. The combined average daily trading volume in the New York Stock Exchange and Nasdaq Stock Market in the first four months of 2011 fell 15% from 2010, to an average of 6.3 billion shares a day. Trading activities has been declining throughout 2011, with April's daily average of 5.8 billion shares marks the lowest month since May 2008. Decrease of sharp movements in stock prices which were frequent during the period from 2008 to the first half of 2010, can be seen in a decline in the Chicago Board Options Exchange volatility index, the VIX, which fell to its lowest level in April 2011 since July 2007.
The recent volumes of trading activity, to some degree, are regarded as more natural levels than during the financial crisis and its aftermath. Some described those lofty levels of trading activity were never an accurate picture of demand among investors. It was a reflection of computer-driven traders passing securities back and forth between day-trading hedge funds. The flash crash exposed this phantom liquidity. High-frequency trading firms are increasingly active in markets like futures and currencies, where volatility remains high.
Trades by high-frequency traders account for 28% of the total volume in the futures markets, which include currencies and commodities, an increase from 22% in 2009.
However, the growth of computerized and high-frequency trading in commodities and currencies has coincided with a series of "flash crashes" in those markets. The role of human market makers, who can match buyers and sellers and provide liquidity to the market, is now more and more played by computer programs. If those program traders pull back from the market, then big "buy" or "sell" orders can lead to sudden, big swings. It increases the probability of surprise distortions same as the equity markets, according to a professional investor. In February 2011, the sugar market took a dive of 6% in just one second. On March 1, Cocoa-futures prices dropped 13% in less than a minute on the IntercontinentalExchange. Cocoa plunged $450 to a low of $3,217 a metric ton before rebounding quickly. The U.S. dollar tumbled against the yen on March 16, falling 5% in minutes, one of its biggest moves ever. According to a former cocoa trader: ' "The electronic platform is too fast; it doesn't slow things down" like humans would. '
See also
- List of largest daily changes in the Dow Jones Industrial Average
- High-frequency tradingHigh-frequency tradingHigh-frequency trading is the use of sophisticated technological tools to trade securities like stocks or options, and is typically characterized by several distinguishing features:...
- Algorithmic tradingAlgorithmic tradingIn electronic financial markets, algorithmic trading or automated trading, also known as algo trading, black-box trading or robo trading, is the use of electronic platforms for entering trading orders with an algorithm deciding on aspects of the order such as the timing, price, or quantity of the...
External links
- Preliminary Findings Regarding the Market Events of May 6, 2010, Report of the staffs of the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues, May 18, 2010
- Findings Regarding the Market Events of May 6, 2010, Report of the staffs of the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues, September 30, 2010
- The Microstructure of the ‘Flash Crash’: Flow Toxicity, Liquidity Crashes and the Probability of Informed Trading, David Easley (Cornell University), Marcos López de Prado (Tudor Investment Corp., RCC at Harvard University) and Maureen O'Hara (Cornell University), The Journal of Portfolio Management, Vol. 37, No. 2, pp. 118–128, Winter 2011
- The Flash Crash: The Impact of High Frequency Trading on an Electronic Market, Andrei A. Kirilenko (Commodity Futures Trading Commission) Albert S. Kyle (University of Maryland; National Bureau of Economic Research (NBER)) Mehrdad Samadi (Commodity Futures Trading Commission) Tugkan Tuzun (University of Maryland - Robert H. Smith School of Business), October 1, 2010
- Regulatory Issues Raised by the Impact of Technological Changes on Market Integrity and Efficiency, Technical Committee of the International Organization of Securities Commissions, July, 2011