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How One Trade Set Off Flash Crash

Today’s joint Securities and Exchange Commission and the Commodity Futures Trading Commission report discussed the causes of the May 6 Flash Crash in detail.

NYSE Trader
Photo: Oliver Quillia for CNBC.com
NYSE Trader

The most surprising revelation in the report is that a single trade, against a backdrop of high volatility and downward price pressure, seems to have been responsible for the crash.

A firm identified by officials as Waddell & Reed Financial of Kansas attempted to execute an algorithmic sale of 75,000 S&P 500 futures contracts, referred to as E-minis, valued at $4.5 billion, in order to hedge an existing equity position.

The algorithm was programmed to sell the E-minis so that the sell volume was to equal 9 percent of the total volume, calculated over the previous minute; however, the algorithm did not specify the sell price or the time frame of the trade.

The execution of the sell algorithm resulted in the single largest net change in position of any trader in E-minis since the beginning of the year. (During the prior twelve months, only twice before had a single-day sell program of equal or larger size been executed: one of those trades was executed by Waddell & Reed.)

On this occasion, however, with downward pressure already on the equities markets, the algorithm was executed extremely rapidly — taking only twenty minutes to complete.

High Frequency Traders (HFTs), fundamental buyers, and cross-market arbitrageurs were the buyers on the other side of the trade. After initially accumulating long positions, HFT buyers, who were likely the first purchasers of the E-Minis from the algorithmic sell, began to reduce their positions. Due to the volume and speed of execution, the trades were not properly absorbed by the market.

This caused a liquidity crisis. The report goes on to specify two separate though related liquidity crises that resulted from the ramifications of the sell algorithm. The first crisis was caused by the rapid unloading of Emini futures contracts; the second, was caused by cross-market arbitrageurs, rapidly liquidating equivalent positions in the underlying equities.

When the individual equities were sold off, creating downward pressure on prices, the automated systems used by liquidity providers programmatically paused. (These pauses are a built in safeguard to allow liquidity providers to better manage risk once prices move beyond predefined thresholds.)

After the system pause, liquidity providers engaged in three distinct behaviors to protect their positions: 1) Some widened the spreads between their offers to buy and sell; 2) others reduced the liquidity they offered; and 3) some withdrew from the market entirely. After executing these strategies, some liquidity providers were forced to resort to manual trading, and could not respond to the 10X increase in trade volume among declining prices.

With market makers retreating, some HFTs began to halt trading completely, as they were exposed to severe price dislocations. The OTC markets, which usually route orders internally, began sending some—or all—of their volume to exchanges, despite the fact that liquidity at the exchanges was drying up.

This complex combination of factors presumably created a positive feedback loop, which became self-reinforcing.


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