Last Friday, the Securities and Exchange Commission and the Commodity Futures Trading Commission issued their joint report on what caused the sudden drop in stock prices on Wall Street in mid-afternoon on May 6th.  The full report is 87 pages–plus some colorful charts–long.

The first eight pages give a summary of the findings, which MarketWatch has edited–that is, deleted the footnotes–and presented in two pages that are easier on the eyes.

some background…

1.  I posted twice about the mini-crash when it occurred.  Here are links to the first and second post.

2.  Traditional investment management companies, seeing the appeal of hedge funds to their client base, have created their own hedge fund-like offerings over the past half-decade.  Some have become very popular and are now very large.  One of these, unnamed in the report, triggered the market fall when it placed a large computer-controlled order to sell a specific stock index futures contract, the E-mini S&P 500.

3.  One of the tactics day traders use is to scan the market for unusual movement–up or down, it doesn’t matter–in stocks whose trading patterns they feel familiar with.  When they see abnormal pressure, they’ll step in to take the other side of the trade.  They figure the pressure is temporary and that when it ends the stock will revert to its normal trading level.  They’ll then unwind their position at a profit.  For longer-term market participants, day traders provide a useful liquidity-enhancing service that allows them to shift money from one stock to another more quickly.

4.  Brokers, and especially the big discount brokers catering to individual investors, have their own internal market-making operations.  They try, if possible (they have to abide by rules on searching for better prices from third parties), to match, in-house, one customer’s buy order with another’s sell.  This way, they earn the bid-asked spread, which can be much more than the commission they charge.

The report calls firms that do a lot of this “internalizers.”  There’s nothing necessarily wrong with doing this, either.  After all, someone is going to earn the spread.  The relevant point is, though, that  under normal conditions this order flow never hits the NYSE or other exchanges.

…to understand what happened on May 6th

At 2:32 pm on May 6th, the unnamed mutual fund company initiated an order to sell 75,000 E-mini S&P 500 futures contracts (about $4 billion worth, or a few percent of typical daily trading volume).  They told the SEC/CFTC they did this to try to protect stock positions against losses in a market that had been drifting downward for about two weeks.  The E-mini, traded on the Chicago Mercantile Exchange’s Globex electronic trading platform, is preferred by many to other contracts that are traded using the older “open outcry” (that is, yelling) system.

The portfolio manager who placed the order gave two instructions to his trading desk:

–the order was to be executed by computer, not by a human trader, and

–the order would be fed into Globex in amounts no more than 9% of what had been traded in the prior minute.

The manager could have given other instructions–say, put in a price limit, or a specification of a maximum amount of the order to be done before checking with him/her–but didn’t.

The institution had apparently done an E-mini sell this large only once before.  On the prior occasion, the trade was done partly by humans, partly by computer, and took five hours.  Maybe it didn’t work out as well as the initiating portfolio manager would have liked.  In any event, this time the manager put the order right to the computer, cutting out the human fail-safe.

Either by accident or portfolio manager design, the May 6th trade was completed in 20 minutes, leaving a securities market train wreck in its wake.

(The SEC/CFTC report simply records the fact of this trade.  As someone who has worked with various kinds of trading rooms for three decades, however, I find the account of the trade really strange.

This was a $4 billion order, so a senior person placed it.  Yet, he/she doesn’t seem to have realized how huge it was–it and the earlier sell order were two of the largest three one-day sells in the E-mini of the prior year. At the very least, he/she seems to have made no provision to monitor the trade, even though a new procedure was being used.

No one at the firm seems to have sensed that the trade was having negative ripple effects on the financial markets.  Apparently, no one tried to stop the trade before the 75,000 contracts were sold.  The issue isn’t necessarily that one should have a social conscience, although the firm may well have damaged its professional reputation.  Again, no comments from SEC/CFTC, but the trade execution must have been at terrible prices. Comments in the SEC/CFTC report do suggest that the portfolio manager involved had little grasp of basic features of the E-mini market.)

the order hits the market

As the order began to be executed, short-term traders did their thing.  They took the other side of the trade and sat back to wait.  When the selling stopped, they planned to reverse their positions at a profit.   That would pay for the big lunches they’d just had, or maybe for summer camp for the kids.  Some day traders also looked for discrepancies between futures prices and the physical market and hedged–transmitting, as usual, the futures market action into physical stock trading.

But the mutual fund computer didn’t stop.  Day traders started to get worried, and started to offload some of the risk they had taken on that day, both from this trade and others.  In other words, they started selling, too.  Their defensive behavior had the perverse effect of increasing E-mini volume, however. That meant that, although counterparties were signaling that they didn’t want to trade any more, the mutual fund computer obeyed its instructions and upped the speed of its selling.

Several things happened next:

–market makers either stopped making markets entirely or set bid-asked spreads that they thought only a crazy person would act on,

–which caused a trading halt in the E-mini, helping that market to stabilize and recover.

–retail investors, nervous after two weeks of decline, bad economic news and the market dropping that day, panicked and placed market orders to sell physical stock as well, and

–at least one big “internalizer” effectively shut down in-house operations and directed a big wave of sell orders to third parties–where the loony bids and asks resided.

After twenty minutes, punctuated by the saving grace of the trading halt, the mutual fund computer was sated and shut itself down.  The market rebound was already under way.

lessons learned

I imagine that one person has learned that you shouldn’t put in an order to sell $4 billion worth of anything–especially something new–without watching for a while to see what happens.

The rest of the world has learned that accidents like this can happen.  Presumably, the next time the markets won’t panic as much.

At the end of the day, the exchanges and FINRA (Financial Industry Regulatory Authority) huddled together and decided to void all trades that were more than 60% away from a reference price they determined.  Two aspects of this decision troubled market participants:  it came after the fact, and the process wasn’t clear.  Since the exchanges and FINRA represent the brokers, the natural suspicion–correct or not–is that they cancelled mostly trades they lost money on.  Not an idea that encourages buyers during market declines.

The SEC and FINRA have since developed a set of rules to cover what trades, if any, will be voided as/when this kind of market decline recurs.