Friday, October 1, 2010

SEC-CFTC Issues Report On May 6, 2010 Stock Market Flash Crash

The SEC and CFTC issued their joint report on the stock market flash crash of May 6, 2010. The full 104 page report is available from the SEC here or from my upload on Scribd here.

The executive summary was not released as a separate document and is included in the full report.

I have reprinted from the Executive Summary part of the report, the Lessons Learned section below:
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. Moreover, the interaction between automated execution programs and algorithmic trading strategies can quickly erode liquidity and result in disorderly markets. As the events of May 6 demonstrate, especially in times of significant volatility, high trading volume is not necessarily a reliable indicator of market liquidity.

May 6 was also an important reminder of the inter-connectedness of our derivatives and securities markets, particularly with respect to index products. The nature of the cross-market trading activity described above was confirmed by extensive interviews with market participants (discussed more fully herein), many of whom are active in both the futures and cash markets in the ordinary course, particularly with respect to “price discovery” products such as the E-Mini and SPY. Indeed, the Committee was formed prior to May 6 in recognition of the continuing convergence between the securities and derivatives markets, and the need for a harmonized regulatory approach that takes into account cross-market issues. Among other potential areas to address in this regard, the staffs of the CFTC and SEC are working together with the markets to consider recalibrating the existing market-wide circuit breakers – none of which were triggered on May 6 – that apply across all equity trading venues and the futures markets.

Another key lesson from May 6 is that many market participants employ their own versions of a trading pause – either generally or in particular products – based on different combinations of market signals. While the withdrawal of a single participant may not significantly impact the entire market, a liquidity crisis can develop if many market participants withdraw at the same time. This, in turn, can lead to the breakdown of a fair and orderly price-discovery process, and in the extreme case trades can be executed at stub-quotes used by market makers to fulfill their continuous two-sided quoting obligations.

As demonstrated by the CME’s Stop Logic Functionality that triggered a halt in E-Mini trading, pausing a market can be an effective way of providing time for market participants to reassess their strategies, for algorithms to reset their parameters, and for an orderly market to be re-established.

May 6, 2010 Market Event Findings In response to this phenomenon, and to curtail the possibility that a similar liquidity crisis can result in circumstances of such extreme price volatility, the SEC staff worked with the exchanges and FINRA to promptly implement a circuit breaker pilot program for trading in individual securities. The circuit breakers pause trading across the U.S. markets in a security for five minutes if that security has experienced a 10% price change over the preceding five minutes. On June 10, the SEC approved the application of the circuit breakers to securities included in the S&P 500 Index, and on September 10, the SEC approved an expansion of the program to securities included in the Russell 1000 Index and certain ETFs. The circuit breaker program is in effect on a pilot basis through December 10, 2010.

A further observation from May 6 is that market participants’ uncertainty about when trades will be broken can affect their trading strategies and willingness to provide liquidity. In fact, in our interviews many participants expressed concern that, on May 6, the exchanges and FINRA only broke trades that were more than 60% away from the applicable reference price, and did so using a process that was not transparent.

To provide market participants more certainty as to which trades will be broken and allow them to better manage their risks, the SEC staff worked with the exchanges and FINRA to clarify the process for breaking erroneous trades using more objective standards.13 On September 10, the SEC approved the new trade break procedures, which like the circuit breaker program, is in effect on a pilot basis through December 10, 2010.

Going forward, SEC staff will evaluate the operation of the circuit breaker program and the new procedures for breaking erroneous trades during the pilot period. As part of its review, SEC staff intends to assess whether the current circuit breaker approach could be improved by adopting or incorporating other mechanisms, such as a limit up/limit down procedure that would directly prevent trades outside of specified parameters, while allowing trading to continue within those parameters. Such a procedure could prevent many anomalous trades from ever occurring, as well as limit the disruptive effect of those that do occur, and may work well in tandem with a trading pause mechanism that would accommodate more fundamental price moves.

Of final note, the events of May 6 clearly demonstrate the importance of data in today’s world of fully-automated trading strategies and systems. This is further complicated by the many sources of data that must be aggregated in order to form a complete picture of the markets upon which decisions to trade can be based. Varied data conventions, differing methods of communication, the sheer volume of quotes, orders, and trades produced each second, and even inherent time lags based on the laws of physics add yet more complexity.

Whether trading decisions are based on human judgment or a computer algorithm, and whether trades occur once a minute or thousands of times each second, fair and orderly markets require that the standard for robust, accessible, and timely market data be set quite high. Although we do not believe significant market data delays were the primary factor in causing the events of May 6, our analyses of that day reveal the extent to which the actions of market participants can be influenced by uncertainty about, or delays in, market data.

Accordingly, another area of focus going forward should be on the integrity and reliability of market centers’ data processes, especially those that involve the publication of trades and quotes to the consolidated market data feeds. In addition, we will be working with the market centers in exploring their members’ trading practices to identify any unintentional or potentially abusive or manipulative conduct that may cause system delays that inhibit the ability of market participants to engage in a fair and orderly process of price discovery.
My May 19, 2010, blog post on the preliminary version of the SEC-CFTC report on the flash crash is available here.

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