Flash Crash "Cause" Found

It usually is never a good sign that a major government report is released on a Friday afternoon. Often it means that the contents don't reflect well on the government agency releasing the report.

Last Friday afternoon, the US  Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) finally released a 104-page report detailing the findings of their joint investigation (here in PDF format) into the so-called stock market "flash crash" on May 6th of this year

According to this article in the Financial Times of London, "a $4.1bn sale of stock index futures by a single institutional investor who was hedging against the risk of a market downturn" sparked the crash. The institutional investor - not named officially in the report but widely reported as Waddell & Reed - ordered an extremely quick sell order to be executed. 

Waddell & Reed in mid-May denied it has caused the flash crash - and apparently still denies it.

The SEC/CFTC report states what happens in this fashion:

"Generally, a customer has a number of alternatives as to how to execute a large trade. First, a customer may choose to engage an intermediary, who would, in turn, execute a block trade or manage the position. Second, a customer may choose to manually enter orders into the market. Third, a customer can execute a trade via an automated execution algorithm, which can meet the customer’s needs by taking price, time or volume into consideration. Effectively, a customer must make a choice as to how much human judgment is involved while executing a trade."

"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 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 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."

Of course, to say that Waddell & Reed "caused" the flash crash is a gross overstatement that the SEC and CFTC acknowledge. What the "flash crash" report really exposed are the continuing problems in automated market systems that were first exposed in the Black Monday crash of October 1987, and which the regulators have been trying to play catch-up with ever since.

In its lessons learned section, the SEC/CFTC report states that:

"May 6 was also an important reminder of the inter-connectedness of our derivatives and securities markets, particularly with respect to index products."

It also states that:

"... 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. Moreover, the interaction between automated execution programs and algorithmic trading strategies can quickly erode liquidity and result in disorderly markets."

The FT interviewed Michael Yoshikami, the chief investment strategist at YCMNET Advisors, who summed up that SEC/CFTC report as being "a good autopsy" but that it failed to it answer the question about what the SEC and CFTC are going to recommend to increase trust and confidence in how the stock market operates.

The increase in trust and confidence is needed.

An AP-CNBC poll of investor confidence released in September indicated that 92% of the individual investors surveyed don't believe regulators "have a firm grasp on Wall Street", and that the flash crash was merely another indication of that. In addition the poll indicates that, "Only 13% surveyed think the market is fair for small investors, while nearly 9 out of every 10 think it's perfectly fair for investment banks, hedge funds and professional traders."

Mr Yoshikami went on to say that:

"We have one firm ... that according to the SEC really was the trigger of this whole cascade. When you consider the number of firms out there making trades the possibility this could happen again, in my opinion, is very high."

And with even more rapid computerized trading technology just over the horizon and the increasing use of machine readable news, I don't think it really is a possibility - it is a certainty.