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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Goolsbee, Supply-Side, Income And Wealth Effects

A comment I posted on Rortybomb, "Goolsbee on Supply-Side and Subprime" by Mike Konczal:

The rise in executive and high-income compensation mentioned in 2 and 3 is in large part due to the sharp rise in the stock market as pay shifted from salary to stock incentives and stock options, starting around 1980 as more income was generated from stock investments than salaries. An effect of a tax law change itself.

To make statements about effects of marginal tax cuts on high-income earners, studies have to separate the effects of taxes on stock compensation (options, etc.) and wages.

They studies do not. For example, the timing switch mentioned in three is in part a decision about when to recognize the wealth gain in stock option compensation. The proper question is not when an executive converts the investment and pays taxes on it. Of course, a rational executive will pick a lower tax year. The studies fail to recognize that the wealth, the appreciation in the stock price, has already occurred and exists independent of its conversion into a taxable event.

The more relevant questions is to what extent did tax policy aid or hinder that stock’s appreciation and do corporations adjust their incentive compensation policies to offset expected tax effects. If corporations adjust future realized compensation for expected tax changes, then of course, corporate income also changes in an opposite direction to gross income to keep after tax income level.

Over the period from Kennedy to Bush, the tax laws increased relating to exceeding a maximum executive compensation level. The consequence was that the amount of executive compensation paid as stock options, etc. increased tremendously.

To make a positive, negative or neutral statement about marginal tax rates on high-income taxpayers, the studies have to distinguish tax effects on wages versus wealth creation (which can occur without recognized taxable income) versus stock market effects.

High wealth and high-income effects are not synonymous and different taxes have different effects on these two components.

There is still a lot of research needed to answer the questions about the effect of marginal tax rates. Yes, a lower marginal tax rate speeds up income recognition. The more relevant, important and difficult question is did the decrease in marginal tax rates contribute to the increased wealth that was recognized in the earlier period?

A paper than definitively answered positively or negatively the supply side effect of marginal tax cuts would have to look both at income and wealth increases (decreases) due to marginal tax cuts.

Looking at either wealth or income creation separately cannot answer the question about marginal tax effects. Both components need to be considered at the same time.

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Home Values Were Not In A Bubble

Houses are like other assets that are bought and sold in a marketplace. The prices of the transactions in the housing market reflect the economic value to the buyers and the sellers and value is based on future expectations about the economic fundamentals of housing.

In the US and worldwide there has been a noticeable decline in the value of homes. Some argue that home prices were artificially inflated due to a "bubble." Others believe in efficient markets and that the decline in home values is a rational response to a change in economic circumstances and expectations.

Houses are a multi-generational asset in that they are a consumer durable that can been passed on from one generation to another. In a rational expectations, efficient market world which is the world economic research finds we live in, house price changes are due to changes in the expectations of the economic fundamentals related to the need, demand and value of houses. Thus, current house prices reflect their true economic value and homes are not undervalued whether due to the unavailability of credit or for other reasons. Arms-length housing market transactions, of which there are still many, occur at the true current price of housing.

Much recent academic work supports the idea that a sharp price rise and decline in "bubbles" is actually a rational economic response and markets are efficient even in so called "bubbles". For example, see the Wikipedia article on tulip mania and a 2004 article in Slate, Bulb Bubble Trouble [Weblink updated].

So, instead of trying to use government money to artificially shore up house prices, a more rational response to the decline in the value of homes, is to ask what is the price change in the housing market telling us about the future value of housing and to see if that is something that is undesirable. If the expected outcome is not what we would like to see happen and is changeable, then we should do the things to change that outcome in our economy.

Some of the possible future scenarios which would decrease the current value of a home are:

1. a significant and long-term decline in household formation.
2. a significant and long-term decline in population growth in the US due to changes in birthrate or immigration policies.
3. an increase in adult children living in their parents home (including after marriage or cohabitation).
4. an expectation of an increase in mortality or a shortening of life expectancy due to war, disease or natural or man made disasters.
5. a change in our preferences so as to prefer multi-family or apartment type dwellings as opposed to single family homes decreasing the need for single family homes.
6. a significant increase in the costs of owning and maintaining a home which lowers its economic value to a purchaser because of the expected increase cash outflow during ownership.
7. a decline in both household income or the expected growth rate of household income.
8. an alternative technology for building homes which will dramatically reduce the costs of building new houses.
9. a change in home related taxation such as a denial of mortgage interest or real estate taxes deductions.
10. a substantial expected increase in real estate taxes.
11. other possibilities that affect the economic value of a home that I have not mentioned.

Some ideas mentioned above are testable. For example, I was going to mention global warming but a recent paper about house price declines in California observed that the decline is greater in central California than along the coast which is contrary to what would happen to house prices along the coast due to rising sea levels due to global warming. See the paper by OFHEO, "Recent Trends in House Price", pages 4 and 5 and note 6 at http://www.ofheo.gov/media/research/pricesandfinancing.pdf [The Office of Federal Housing Enterprise Oversight (OFHEO) no longer exist and I am unaware of an updated weblink to the paper.]

The point of this post is that to most economists who believe in economic value, efficient markets and rational expectations, the current decline in home prices is a rational response to a change in expectations about the value of homes. If there were not this belief that current homes are fairly valued, then buyers would be buying up and warehousing the depressed priced homes, the foreclosed homes and abandoned homes. The fact that buyers are not rushing in shows that the current prices of homes are fair and homes are not undervalued.

Markets Are Efficient But Can Be Wrong

Markets are efficient and the press and the other media often ignore or misstate the concept's meaning and ideas.

A market is efficient if past prices cannot be used to predict future prices. The period to period change in the prices of actively traded assets such as stocks is random and it is this randomness that makes stock efficient.

In an efficient market, as in all other random markets, the best basis for predicting tomorrow's price is today's price plus a gain for the risk of buying the stock. Likewise, the price of the asset traded in an efficient market already reflects the effects of any information that is available whether through announcement, deduction, logic or expectation. Numerous studies over the past fifty years have upheld the efficiency of actively traded markets.

So any statement about the future movement of a stock's price based on its previous stock price movement is hogwash no matter the terminology used such as top, bottom, stochastic, candlestick, capitulation, and many others. Likewise, any statement that a stock price does not reflect announced information or that it will take several days for the stock price to reflect the news is also hogwash.

The concept of efficient markets does not mean that a market's prediction about a stock's price is always correct. The price in an efficient market is the market's best guess based on all knowable information. The market can guess wrong. Just as in any prediction about future events that have not taken place yet, a guess can be wrong or unexpected events can happen. In an efficient market, the price of a stock is fair in that it is just as likely to be too high as it is too low and no historical information about past stock prices or past events can give an investor an edge over a naïve investor who just buys and holds.