U.S. federal regulator report reveals cause of May 6 stock market "flash crash"

U.S. federal regulator report reveals cause of May 6 stock market "flash crash"

2010-10-02 08:52:32 GMT+7 (ICT)

NEW YORK CITY (BNO NEWS) – The Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission on Friday released a report that outlined the causes of the May 6 “flash crash†that sent the stock market into a downward spiral, revealing that one single large trade was responsible, the Wall Street Journal reported.

Federal regulators said that the firm, which was Overland Park, Kansas-based Waddell & Reed Financial Inc., chose to sell a big number of futures contracts using a computer program that worked by clearing available buyers in the market. A spokesman for the company refused to comment other than saying that the firm doesn’t intend to “disrupt†trading through its actions.

The 104-page report clarified the high-frequency trades and the role that it had in the crash. The report shows six 12 high-frequency trading firms that remained in the market as stocks crashed, however, those firms took “significant†buying power out of the market.

While the report wasn’t expected to make policy recommendations, it lightly touched on how the rules from the SEC and other regulators had set the stage for a market crash. Since May 6, the SEC has tested rules that are designed to briefly halt trading in specific individual stocks during sharp moves or prevent them from being moved beyond a certain percentage limit.

The kind of trade that Waddell & Reed performed was not an unusual one for the firm, which, at the time managed around $25 billion. The fund’s strategy often involved placing occasional bets that the stock market will fall as a hedge against its individual stock holdings. It was also not unusual that the firm used a computer program, known as a trading “algorithm†that is designed to stand in for a human trader and parse out buying or selling that is based on different values.

Typically, traders choose algorithms that consider trading volume, price changes, and the amount of time to complete a trade. However, Waddell opted for an algorithm that was designed to sell 75,000 E-mini contracts at a pace that would range up to 9 percent of trading volume without taking into account any other factors. The report detailed how a similar-sized trade in 2010 took around five hours to complete, but this one unloaded the entire trade on the market in only 20 minutes.

The report said that the key lesson of the incident that was in times of significant volatility, “high trading volume is not necessarily a reliable indicator of market liquidity.â€

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