Two years after the frightening spring day when the Dow Jones Industrial Average lost and regained about 600 points in a matter of minutes, we still don’t really know why. This is a problem, because it means something similar -- or worse -- could happen again.
The Flash Crash of May 6, 2010, was more than a mere technical glitch. A hedge fund in Dallas lost several million dollars when the price of options it was buying suddenly spiked from 90 cents to $30 per contract. A man named Mike McCarthy lost $17,000 because his order to sell shares in Procter & Gamble Co. happened to be executed at roughly 2:46 p.m., just after the price hit rock bottom.
The crash brought a different kind of trouble for the Kansas-based investment company Waddell & Reed Financial Inc. In a September 2010 report, the Commodity Futures Trading Commission and the Securities and Exchange Commission fingered a single “fundamental seller” -- easily identified as Waddell & Reed -- as the culprit behind the crash. At 2:32 p.m., the report asserted, the company triggered a cascade of selling by trying to unload 75,000 so-called E-mini futures contracts, the value of which reflects investors’ perceptions about the future of the Standard & Poor’s 500 Index. “Lone $4.1 Billion Sale Led to `Flash Crash’ in May,” the New York Times duly reported.
The CFTC-SEC report focused on the concept of liquidity, or how easily a security can be traded without moving its price. Waddell & Reed’s sell order, the logic goes, was so large and hit the market so hard that it overwhelmed the available buyers. This sucked liquidity out of the market and allowed prices to go into freefall.
Concern for Price
Problem is, that’s not exactly what happened. As documented by the market-data firm Nanex, Waddell & Reed didn’t actually go into the market and sell, as the report suggested, without any concern for the price.
Eric Scott Hunsader, a software engineer and the founder of Nanex, parsed 6,483 trades that Waddell & Reed made as it tried to sell the 75,000 E-mini contracts. He found that the trades were passive, meaning that Waddell & Reed stood ready to sell at preset prices if buyers appeared. The company’s execution broker fed the orders into the market throughout the day -- a tactic specifically designed to minimize the price impact of a large sale.
In other words, Waddell & Reed was providing liquidity to the market, not removing it.
The actual crisis struck in the three minutes between 2:41 p.m. and 2:44 p.m., when the market fell another 5 percent to 6 percent. Hunsader’s analysis suggests this plunge was caused by high-frequency traders. They typically act as liquidity providers, standing ready to buy and sell at certain price levels. But the day’s volatility prompted them to dump their holdings to avoid losses. In a matter of minutes, they actively sold an accumulated stock of about 2,000 E-mini contracts. It was this selling, not Waddell & Reed’s passive orders, that caused liquidity to disappear.
There is nothing blameworthy about what the high-frequency traders did. Market makers aren’t charities, and their algorithms were only saving their skins amidst extreme market turbulence. Their actions do, however, rather undermine the common argument that high-frequency traders bring wonderful benefits to the market through the liquidity they provide. That liquidity, as many have pointed out, has a rather ghostly quality and tends to vanish when needed most.
Also troubling is the way the CFTC and SEC report, in placing responsibility for the crash on Waddell & Reed, contradicted its own definition of liquidity: “buy-side and sell-side market depth, which is comprised of resting orders that market participants place to express their willingness to buy or sell at prices equal to, or outside of (either below or above), current market levels.”
This is the standard industry use of the term. It implies that someone placing limit orders in the book -- precisely what Waddell & Reed was doing -- provides liquidity to the market. Yet the CFTC-SEC report, as Hunsader has documented, nevertheless refers repeatedly to Waddell & Reed’s trading as “taking” or “competing for” liquidity.
The SEC referred questions to the CFTC, where a spokesman said the commission stands by the report but declined to comment further.
Given the evidence, the report is starting to look like a case of interpreting the data creatively to match a foregone conclusion: The crash was caused by some exceptional and unusual shock to the market, not by the inherent instability within the ecology of high-frequency trading. Don’t worry, therefore -- everything is OK.
Too bad for Waddell & Reed.
(Mark Buchanan, a theoretical physicist and the author of “The Social Atom: Why the Rich Get Richer, Cheaters Get Caught and Your Neighbor Usually Looks Like You,” is a Bloomberg View columnist. The opinions expressed are his own.)
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