“Hot-potato” trading by computer-driven firms and automated sales of stock futures without regard to price helped trigger the May 6 crash, turning an orderly sell-off into an $862 billion rout as buy orders evaporated, the SEC and CFTC said Friday in a report.
“One key lesson is 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,” according to the report.
A large trader’s routine attempt to hedge against losses helped set off a chain of events that sent the Dow Jones industrial average down 998.50 points, according to the 104-page report.
“Some market makers and other liquidity providers widened their quote spreads, others reduced offered liquidity, and a significant number withdrew completely from the markets,” according to the report. High-frequency traders, “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 SEC and CFTC found in their initial report about May 6 that electronic trading firms supplying bids and offers reined in their activity, increasing the “mismatch of liquidity” and potentially exacerbating the decline.
While the report doesn’t name the large trader, two people with knowledge of the findings said it was Waddell & Reed Financial. The firm sold E-mini futures on the S&P 500 index, helping start the crash, according to the sources. E-minis are contracts offered by CME Group Inc. that let investors bet on things such as the S&P 500.
The report added: “The sell algorithm used by the large fundamental seller 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 a reliable indicator of market liquidity.”
Some high-speed trading firms began assessing whether the rapid price moves were the result of erroneous data and how their systems were keeping up with the high volume of data, according to the report. They also sought to determine what impact the moves had on their risk and position limits and their profitability, and how the prospect of trades being canceled would affect their holdings.