Donald Marron calls our attention to the report of the CFTC and the SEC on the causes of bizarre prices at which some stocks traded last May.
According to the CFTC-SEC report, at 2:32 p.m. on May 6, a large trader initiated an order to sell 75,000 E-mini S&P500 futures contracts in order to hedge its existing equity positions:
This large fundamental trader chose to execute this sell program via an automated execution algorithm (“Sell Algorithm”) that was programmed to feed orders into the June 2010 E-Mini market to target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time.
The execution of this sell program resulted in the largest net change in daily position of any trader in the E-Mini since the beginning of the year (from January 1, 2010 through May 6, 2010)…. 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 combined selling pressure from the Sell Algorithm, HTFs [high frequency traders] and other traders drove the price of the E-Mini down approximately 3% in just four minutes from the beginning of 2:41 p.m. through the end of 2:44 p.m….
The Sell Algorithm used by the large trader 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 necessarily a reliable indicator of market liquidity.
What happened next is best described in terms of two liquidity crises– one at the broad index level in the E-Mini, the other with respect to individual stocks.
This episode serves as another reminder, as if we did not have enough already from the financial fireworks in the fall of 2008, that the faith many market participants have in their hedging strategies is misplaced. Aggregate risks cannot be hedged by the aggregate market. Pretending that sufficiently clever algorithms can repeal that physical law will only ensure spectacular breakdowns such as that witnessed May 6, when the absence of the aggregate counterparty becomes dramatically revealed.
It also should remind us that it can be a really stupid plan to sell regardless of the price.
And it is still a really stupid plan even if it comes out of what somebody told you is supposed to be a very smart computer algorithm.
Professor Hamilton,
“Aggregate risks cannot be hedged by the aggregate market” Uuuuuuuhh, can I take that quote and put it in the flaghead of my blog??? No I am not joking.
Ted K: By all means.
I’m a bit perplexed by the reminder; frankly, I don’t understand how it’s relevant.
The report shows that the episode was simply one of market impact costs writ large. Waddell & Reed tried to sell $4.1-billion in notional equity in a single trade in a nervous market. They were able to execute in 20 minutes, but only through incurring market impact costs with an effect sufficiently egregious to be obvious even to a stockbroker. Even to a regulator!
“Aggregate risks cannot be hedged by the aggregate market”
This statement and above events, provide for possible answers to the Treasury bonds prices behavior model in ZLB,should the markets and not a central bank be selling ~ 400 billion fc treasury bills.
They are implications
The several layers of derivatives for the same assets, have to be continuously monitored in prices and volume,the more layers of derivatives the greater the sensitivity.
Everyone knows this since the subprime derivatives debacle.
Derivatives will not be addressed before 2012 (source Bloomberg)
Should we be taking the SEC’s report at face value?
The Chicago Mercantile Exchange has categorized W&R’s transaction as routine.
From the CME:
http://cmegroup.mediaroom.com/index.php?s=43&item=3068&pagetemplate=article
Zero Hedge has also republished a series of research papers done by Nanex on HFT quote stuffing patterns around and during the crash. Nanex postulated quote stuffing was directly responsible for the May 5 crash.
The articles are still up, but I don’t have time to find the links.
The SEC report just doesn’t ring true to me.
The latest version of the Nanex report is at:
http://www.nanex.net/FlashCrashFinal/FlashCrashSummary.html
An earlier version:
http://www.nanex.net/20100506/FlashCrashAnalysis_Intro.html
Part 4 of the “earlier version” shows the obvious quote stuffing. If I was doing this, I would have sent random quote requests. These “saw”, “knife” or whatever algorithms make it real easy to get caught. But hey, it’s the SEC. The only things they catch are porn site STD’s.
The SEC report is simply trying to obfuscate. The W&R transaction took the grand prize, but there were tons of really bizarre collapsing charts out there on May 5, many of which showed up an hour or more before the “flash crash”.
In particular the high-yield ETFs both imploded about an hour before W&R cratered the entire S&P 500. JNK fell from being down 3% to being down 9% (briefly) right around 2 PM — nearly an hour before our “deep and liquid” markets demonstrated their full absence of both depth and liquidity.
Instead of pointing fingers at one particular trade, which would not have been abnormal in a normally-liquid market, the SEC needs to get off its collective tailbone and understand where the liquidity suddenly vanished to. Because unless investors are shown conclusively that liquidity has been restored, we have to assume a liquidity-starvation flash crash will happen again!
And, in all honesty, the dramatic reduction in trading volume over the last few months (especially the volume sans HFT nonsense) doesn’t do anything to restore confidence either.
Sorry, meant to include a link to charts and other information recorded on flash crash day, demonstrating that JNK / HYG had flash crashes prior to the S&P crash:
http://blog.i4sg.com/2010/05/06/todays-crash-led-by-bond-market-etfs/
In the deregulatory era the SEC morphed from investor protection to market protection. The new rage all round is “liquidity” no matter the fundamentals.
There was a time when the hedge was intrinsic to the investment. The yield or dividend reflected the underlying fundamentals; but no more. The synthetic investment construct makes fools of traditional investors; little different from the foolish savers lending for nothing.
Wasn’t this about the time when the Senate was discussing behind closed doors re Fin Reg and its potential to cost the too big to fails big money. Kinda like a kid who says “if i can n’t make up my own rules, i’ll take my toys( market liquidity) and go home. I ‘ll just step outside in the yard for 20 minutes to give you kids a chance to think it over.” In full daylight no less.
Nanex has released a new report which deals with the Waddell & Reed trades. Apparently, most of the Waddell order occurred after the market bottomed. From 2:44:15 to the bottom at 14:45:30, Waddell was almost absent.
http://www.nanex.net/FlashCrashFinal/FlashCrashAnalysis_W&R.html
This really puts the SEC and CFTC’s report to shame. But efforst like “Findings Regarding the Market Events of May 6, 2010” are never really about truth. Their function is to encourage people to move along quickly without bothering to question the very powerful actors and institutions who have made major mistakes. Blaming a small player like Waddell gets the NYSE and the regulators off the hook. Don’t tell me you’re buyig it JDH.
As for Nanex, their work is exemplary.