2010 Flash Crash
The May 6, 2010 Flash Crash also known as The Crash of 2:45, the 2010 Flash Crash, or simply the Flash Crash, was a United States stock market crash on Thursday May 6, 2010 in which the Dow Jones Industrial Average plunged about 1000 points (about 9%) only to recover those losses within minutes. It was the second largest point swing, 1,010.14 points, and the biggest one-day point decline, 998.5 points, on an intraday basis in Dow Jones Industrial Average history.
On May 6, U.S. stock markets opened and the Dow was down, and trended down for most of the day on worries about the debt crisis in Greece. At 2:42 pm, with the Dow Jones down more than 300 points for the day, the equity market began to fall rapidly, dropping an additional 600 points in 5 minutes for an almost 1000 point loss on the day by 2:47 pm. Twenty minutes later, by 3:07 pm, the market had regained most of the 600 point drop.
SEC/CFTC Report on May 6, 2010
After almost five months of investigations led by Gregg E. Berman, the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) issued a joint report dated September 30, 2010 and titled "Findings Regarding the Market Events of May 6, 2010" identifying the sequence of events leading to the Flash Crash.
The joint report "portrayed a market so fragmented and fragile that a single large trade could send stocks into a sudden spiral," and detailed how a large mutual fund firm selling an unusually large number of E-Mini S&P 500 contracts first exhausted available buyers, and then how high-frequency traders (HFT) started aggressively selling, accelerating the effect of the mutual fund's selling and contributing to the sharp price declines that day.
The SEC and CFTC joint report itself says that "May 6 started as an unusually turbulent day for the markets" and that by the early afternoon "broadly negative market sentiment was already affecting an increase in the price volatility of some individual securities." At 2:32 pm (EDT), against a "backdrop of unusually high volatility and thinning liquidity" that day, "a large fundamental trader (a mutual fund complex) initiated a sell program to sell a total of 75,000 E-Mini S&P 500 contracts (valued at approximately $4.1 billion) as a hedge to an existing equity position." The report says that this was an unusually large position and that the computer algorithm the trader used to trade the position was set to "target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time."
As the large seller's trades were executed in the futures market, buyers included high-frequency trading firms – trading firms that specialize in high-speed trading and rarely hold on to any given position for very long – and within minutes these high-frequency trading firms also started aggressively selling the long futures positions they first accumulated mainly from the mutual fund. The Wall Street Journal quoted the joint report, "'HFTs [then] began to quickly buy and then resell contracts to each other—generating a 'hot-potato' volume effect as the same positions were passed rapidly back and forth.'" The combined sales by the large seller and high-frequency firms quickly drove "the E-mini price down 3% in just four minutes."
From the SEC/CFTC report itself:
- The combined selling pressure from the sell algorithm, HFTs, and other traders drove the price of the E-Mini S&P 500 down approximately 3% in just four minutes from the beginning of 2:41 pm through the end of 2:44 pm. During this same time cross-market arbitrageurs who did buy the E-Mini S&P 500, simultaneously sold equivalent amounts in the equities markets, driving the price of SPY (an exchange-traded fund which represents the S&P 500 index) also down approximately 3%.
- Still lacking sufficient demand from fundamental buyers or cross-market arbitrageurs, HFTs began to quickly buy and then resell contracts to each other – generating a “hot-potato” volume effect as the same positions were rapidly passed back and forth. Between 2:45:13 and 2:45:27, HFTs traded over 27,000 contracts, which accounted for about 49 percent of the total trading volume, while buying only about 200 additional contracts net.
As prices in the futures market fell, there was a spillover into the equities markets. The computer systems used by most high-frequency trading firms to keep track of market activity decided to pause trading, and those firms then scaled back their trading or withdrew from the markets altogether.
The New York Times then noted, "Automatic computerized traders on the stock market shut down as they detected the sharp rise in buying and selling." As computerized high-frequency traders exited the stock market, the resulting lack of liquidity "...caused shares of some prominent companies like Procter & Gamble and Accenture to trade down as low as a penny or as high as $100,000." These extreme prices also resulted from "market internalizers," firms that usually trade with customer orders from their own inventory instead of sending those orders to exchanges, "routing 'most, if not all,' retail orders to the public markets – a flood of unusual selling pressure that sucked up more dwindling liquidity."
While some firms exited the market, firms that remained in the market exacerbated price declines because they "'escalated their aggressive selling' during the downdraft." High-frequency firms during the crisis, like other firms, were net sellers, contributing to the crash.
The joint report said prices stopped falling when, "At 2:45:28 pm, trading on the E-Mini was paused for five seconds when the Chicago Mercantile Exchange ('CME') Stop Logic Functionality was triggered in order to prevent a cascade of further price declines. In that short period of time, sell-side pressure in the E-Mini was partly alleviated and buy-side interest increased. When trading resumed at 2:45:33 pm, prices stabilized and shortly thereafter, the E-Mini began to recover, followed by the SPY." Or as The New York Times reported, "The rout continued until an automatic stabilizer on the futures exchange cut in and paused trading for five seconds, after which the markets recovered."
The joint report noted that after a short while, as market participants had "time to react and verify the integrity of their data and systems, buy-side and sell-side interest returned and an orderly price discovery process began to function," and that by 3:00 pm (EDT), most stocks "had reverted back to trading at prices reflecting true consensus values" and the Flash Crash was over.
CME Group, a large futures exchange, stated that, insofar as stock index futures traded on CME Group were concerned, its investigation found no evidence that high-frequency trading played a role, and in fact concluded that automated trading had contributed to market stability during the period of the crash. Others speculate that an intermarket sweep order may have played a role in triggering the crash.
- The fat-finger theory: In the immediate aftermath of the plunge, several reports indicated that the event may have been triggered by a fat-finger trade, an inadvertent large "sell order" for Procter & Gamble stock, inciting massive algorithmic trading orders to dump the stock; however, this theory was quickly disproved after it was determined that Procter and Gamble's decline occurred after a significant decline in the E-mini S&P 500 Futures contracts. The "fat-finger trade" hypothesis was also disproved when it was determined that existing CME Group and ICE safeguards would have prevented such an error.
- Impact of high frequency traders: Regulators found HFT's exacerbated price declines. As noted above, regulators found that high frequency traders exacerbated price declines. Regulators determined that high frequency traders sold aggressively to eliminate their positions and withdrew from the markets in the face of uncertainty. A July, 2011 report by the International Organization of Securities Commissions (IOSCO), an international body of securities regulators, concluded that while "algorithms and HFT technology have been used by market participants to manage their trading and risk, their usage was also clearly a contributing factor in the flash crash event of May 6, 2010." Other theories postulate that the actions of high frequency traders (HFTs) were the underlying cause of the flash crash. One hypothesis, based on the analysis of bid-offer data by Nanex, Llc., is that HFTs send non-executable orders (orders that are outside the bid-offer spread) to exchanges in batches. Though the purpose of these orders is unknown, some experts speculate that their purpose is to increase noise, clog exchanges, and outwit competitors. However, other experts believe that deliberate market manipulation is unlikely because there is no practical way in which the HFTs can profit from these orders, and it is more likely that these orders are designed to test latency times and to detect early price trends. Whatever the reasons behind the possible existence of these orders, this theory postulates that they exacerbated the crash by overloading the exchanges on May 6. On September 3, 2010 the regulators probing the crash concluded: "that quote-stuffing – placing and then almost immediately cancelling large numbers of rapid-fire orders to buy or sell stocks – was not a “major factor” in the turmoil." Some have put forth the theory High-frequency trading actually has been a major factor in minimizing and reversing the flash crash.
- Large directional bets: Regulators say a large E-Mini S&P 500 seller set off a chain of events triggering the Flash Crash, but did not identify the firm. Earlier, some investigators suggested that a large purchase of put options on the S&P 500 index by the hedge fund Universa Investments shortly before the crash may have been among the primary causes. Other reports have speculated that the event may have been triggered by a single sale of 75,000 E-mini S&P 500 contracts valued at around $4 billion by the Overland Park, Kansas firm Waddell & Reed on the Chicago Mercantile Exchange. Others suspect a movement in the U.S. Dollar to Japanese Yen exchange rate.
- Changes in market structure: Some market structure experts speculate that, whatever the underlying causes, equity markets are vulnerable to these sort of events because of decentralization of trading.
- Technical glitches: An analysis of trading on the exchanges during the moments immediately prior to the flash crash reveals technical glitches in the reporting of prices on the NYSE and various alternative trading systems (ATSs) that might have contributed to the drying up of liquidity. According to this theory, technical problems at the NYSE led to delays as long as five minutes in NYSE quotes being reported on the Consolidated Quotation System (CQS) with time stamps indicating that the quotes were current. However, some market participants (those with access to NYSE's own quote reporting system, OpenBook) could see both correct current NYSE quotes, as well as the delayed but apparently current CQS quotes. At the same time, there were errors in the prices of some stocks (Apple Inc., Sothebys, and some ETFs). Confused and uncertain about prices, many market participants attempted to drop out of the market by posting stub quotes (very low bids and very high offers) and, at the same time, many high-frequency trading algorithms attempted to exit the market with market orders (which were executed at the stub quotes) leading to a domino effect that resulted in the flash crash plunge.
Criticism of the SEC-CFTC report
A few hours after the release of the 104 pages SEC-CFTC report, a number of critics stated that blaming a single order (from Waddell & Reed) for triggering the event was disingenuous. Most prominent of all, the CME issued within 24 hours a rare press release in which it argued against the SEC-CFTC explanation:
- Futures and options markets are hedging and risk transfer markets. The report references a series of bona fide hedging transactions, totaling 75,000 contracts, entered into by an institutional asset manager to hedge a portion of the risk in its $75 billion investment portfolio in response to global economic events and the fundamentally deteriorating market conditions that day. The 75,000 contracts represented 1.3% of the total E-Mini S&P 500 volume of 5.7 million contracts on May 6 and less than 9% of the volume during the time period in which the orders were executed. The prevailing market sentiment was evident well before these orders were placed, and the orders, as well as the manner in which they were entered, were both legitimate and consistent with market practices. These hedging orders were entered in relatively small quantities and in a manner designed to dynamically adapt to market liquidity by participating in a target percentage of 9% of the volume executed in the market. As a result of the significant volumes traded in the market, the hedge was completed in approximately twenty minutes, with more than half of the participant's volume executed as the market rallied – not as the market declined. Additionally, the aggregate size of this participant's orders was not known to other market participants.
- Additionally, the most precipitous period of market decline in the E-Mini S&P 500 futures on May 6 occurred during the 3½ minute period immediately preceding the market bottom that was established at 13:45:28. During that period, the participant hedging its portfolio represented less than 5% of the total volume of sales in the market.
Dr. David Leinweber, director of the Center for Innovative Financial Technology at Lawrence Berkeley National Laboratory, was invited by the Journal of Portfolio Management to write an editorial, in which he openly criticized the government's technological capabilities and inability to study today's markets. Dr. Leinweber wrote:
- The heads of the SEC and CFTC often point out that they are running an IT museum. They have photographic evidence to prove it—-the highest-tech background that The New York Times (on September 21, 2010) could find for a photo of Gregg Berman, the SEC’s point man on the Flash, was a corner with five PCs, a Bloomberg, a printer, a fax, and three TVs on the wall with several large clocks.
- A better measure of the inadequacy of the current mélange of IT antiquities is that the SEC/CFTC report on the May 6 crash was released on September 30, 2010. Taking nearly five months to analyze the wildest ever five minutes of market data is unacceptable. CFTC Chair Gensler specifically blamed the delay on the “enormous” effort to collect and analyze data. What an enormous mess it is.
Nanex, a leading firm specialized in the analysis of high-frequency data, also pointed out to several inconsistencies in the CFTC study:
- Based on interviews and our own independent matching of the 6,438 W&R executions to the 147,577 CME executions during that time, we know for certain that the algorithm used by W&R never took nor required liquidity. It always posted sell orders above the market and waited for a buyer; it never crossed the bid/ask spread. That means that none of the 6,438 trades were executed by hitting a bid. [...] [S]tatements from page 36 of Kirilenko's paper cast serious doubt on the credibility of their analysis. [...] It is widely believed that the "sell program" refers to the algo selling the W&R contracts. However, based on the statements above, this cannot be true. The sell program must be referring to a different algo, or Kirilenko's analysis is fundamentally flawed, because the paper incorrectly identifies trades that hit the bid as executions by the W&R algo.
|Video of the S&P500 futures during the Flash Crash|
As of July, 2011, only one theory on the causes of the flash crash has yet been published by a Journal Citation Reports indexed, peer-reviewed scientific journal. One hour before its collapse, the stock market registered the highest reading of "order flow toxicity" in recent history. The authors of this paper apply widely accepted Market microstructure models to understand the behavior of prices in the minutes and hours prior to the crash. According to this paper, "order flow toxicity" can be measured as the probability that informed traders (e.g., hedge funds) adversely select uninformed traders (e.g., Market makers). For that purpose, they develop the VPIN Flow Toxicity metric, which delivers a real-time estimate of the conditions under which liquidity is being provided. If the order flow becomes too toxic, market makers are forced out of the market. As they withdraw, liquidity disappears, which increases even more the concentration of toxic flow in the overall volume, which triggers a Feedback mechanism that forces even more market makers out. This cascading effect has caused hundreds of liquidity-induced crashes in past, the flash crash being one (major) example of it. One hour before the flash crash, order flow toxicity was the highest in recent history.
However, recent independent studies strongly dispute the last claim. In particular, Andersen and Bondarenko conduct a comprehensive investigation of the two main versions of VPIN used by its creators, one based on the standard tick-rule (or TR-VPIN) and the other based on Bulk Volume Classification (or BVC-VPIN). They find that the value of TR-VPIN (BVC-VPIN) one hour before the crash "was surpassed on 71 (189) preceding days, constituting 11.7% (31.2%) of the pre-crash sample." Similarly, the value of TR-VPIN (BVC-VPIN) at the start of the crash was "topped on 26 (49) preceding days, or 4.3% (8.1%) of the pre-crash sample."
Note that the source of increasing "order flow toxicity" on May 6, 2010 is not determined in Easley, Lopez de Prado, and O'Hara. Whether a dominant source of toxic order flow on May 6, 2010 was from firms representing public investors or whether a dominant source was intermediary or other proprietary traders could have a significant effect on regulatory proposals put forward to prevent another Flash Crash. According to Bloomberg, the VPIN metric is the subject of a pending patent application filed by Maureen O'Hara and David Easley of Cornell University, and Marcos Lopez de Prado, of Tudor Investment Corporation.
A study of VPIN by scientists from the Lawrence Berkeley National Laboratory cites the conclusions of Easley, Lopez de Prado, and O'Hara for VPIN on S&P 500 futures but provides no independent confirmation for the claim that VPIN reached its historical high one hour before the crash:
- 'With suitable parameters, [Easley, Lopez de Prado, and O'Hara] have shown that the [CDF of] VPIN reaches 0.9 more than an hour before the Flash Crash on May 6, 2010. This is the strongest early warning signal known to us at this time.
The Chief Economist of the Commodity Futures Trading Commission and several academic economists published a working paper containing a review and empirical analysis of trade data from the Flash Crash. The authors examined the characteristics and activities of buyers and sellers in the Flash Crash and determined that a large seller, a mutual fund firm, exhausted available fundamental buyers and then triggered a cascade of selling by intermediaries, particularly high-frequency trading firms. Like the SEC/CFTC report described earlier, the authors call this cascade of selling "hot potato trading," as high frequency firms rapidly acquired and then liquidated positions among themselves at steadily declining prices.
The authors conclude:
- Based on our analysis, we believe that High Frequency Traders exhibit trading patterns inconsistent with the traditional definition of market making. Specifically, High Frequency Traders aggressively trade in the direction of price changes. This activity comprises a large percentage of total trading volume, but does not result in a significant accumulation of inventory. As a result, whether under normal market conditions or during periods of high volatility, High Frequency Traders are not willing to accumulate large positions or absorb large losses. Moreover, their contribution to higher trading volumes may be mistaken for liquidity by Fundamental Traders. Finally, when rebalancing their positions, High Frequency Traders may compete for liquidity and amplify price volatility.
- Consequently, we believe, that irrespective of technology, markets can become fragile when imbalances arise as a result of large traders seeking to buy or sell quantities larger than intermediaries are willing to temporarily hold, and simultaneously long-term suppliers of liquidity are not forthcoming even if significant price concessions are offered.
Recent research on dynamical complex networks published in Nature Physics (2013) suggests that the 2010 Flash Crash may be an example of the 'avoided transition' phenomenon in network systems with critical behavior.
Stock market reaction
A stock market anomaly, the major market indexes dropped by over 9% (including a roughly 7% decline in a roughly 15 minute span at approximately 2:45 pm eastern time on May 6, 2010) before a partial rebound. Temporarily, $1 trillion in market value disappeared. While stock markets do crash, immediate rebounds are unprecedented. The stocks of eight major companies in the S&P 500 fell to one cent per share for a short time, including Accenture, CenterPoint Energy and Exelon; while other stocks, including Sotheby's, Apple, and Hewlett-Packard, increased in value to over $100,000 in price. Procter & Gamble in particular dropped nearly 37% before rebounding, within minutes, back to near its original levels. The drop in P&G was broadcast live on CNBC at the time, with commentator Jim Cramer commenting:
("Let's take a look at P&G. Alright, this is going to say everything. P&G is now down 25%.")
Stocks continued to rebound in the following days, helped by a bailout package in Europe to help save the euro. The S&P 500 erased all losses within a week, but selling soon took over again and the indices reached lower depths within two weeks.
The NASDAQ released their timeline of the anomalies during U.S. Congressional House Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises hearings on the flash crash. NASDAQ's timeline indicates that NYSE Arca may have played an early role and that the Chicago Board Options Exchange sent a message saying that NYSE Arca was "out of NBBO". The Chicago Board Options Exchange, NASDAQ, NASDAQ OMX BX, and BATS Exchange all declared SELF HELP against NYSE Arca.
S.E.C. Chairwoman Mary Schapiro testified that "stub quotes" may have played a role in certain stocks that traded for 1 cent a share. According to Schapiro:
- The absurd result of valuable stocks being executed for a penny likely was attributable to the use of a practice called “stub quoting.” When a market order is submitted for a stock, if available liquidity has already been taken out, the market order will seek the next available liquidity, regardless of price. When a market maker’s liquidity has been exhausted, or if it is unwilling to provide liquidity, it may at that time submit what is called a stub quote – for example, an offer to buy a given stock at a penny. A stub quote is essentially a place holder quote because that quote would never – it is thought – be reached. When a market order is seeking liquidity and the only liquidity available is a penny-priced stub quote, the market order, by its terms, will execute against the stub quote. In this respect, automated trading systems will follow their coded logic regardless of outcome, while human involvement likely would have prevented these orders from executing at absurd prices. As noted below, we are reviewing the practice of displaying stub quotes that are never intended to be executed.
Officials announced that new trading curbs, also known as circuit breakers, would be tested during a six-month trial period ending on December 10, 2010. These circuit breakers would halt trading for five minutes on any S&P 500 stock that rises or falls more than 10 percent in a five-minute period. The circuit breakers would only be installed to the 404 NYSE listed S&P 500 stocks. The first circuit breakers were installed to only 5 of the S&P 500 companies on Friday June 11, to experiment with the circuit breakers. The 5 stocks were EOG Resources, Genuine Parts, Harley Davidson, Ryder System, and Zimmer Holdings. By Monday June 14, 44 had them. By Tuesday June 15, the number had grown to 223, and by Wednesday June 16, all 404 companies had circuit breakers installed. On June 16, 2010, trading in the Washington Post Company's shares were halted for five minutes after it became the first stock to trigger the new circuit breakers. Three erroneous NYSE Arca trades were said to have been the cause of the share price jump.
As of September 10, the SEC approved new rules submitted by the national securities exchanges and the Financial Industry Regulatory Authority (FINRA) to expand the circuit breaker program to include all stocks in the Russell 1000 Index and certain exchange-traded funds. The SEC also approved new exchange and FINRA rules that clarify the process for breaking erroneous trades. A list of the securities included in the Russell 1000 Index, which was rebalanced on June 25, is available on the Russell website. The list of exchange-traded products included in the pilot is available on the SEC's website. The SEC anticipates that the exchanges and FINRA will begin implementing the expanded circuit breaker program early next week. The erroneous trade rules were developed in response to the market disruption of May 6. The rules will make it clearer when – and at what prices – trades will be broken by the exchanges and FINRA. As with the circuit breaker program, these rules will be in effect on a pilot basis through Dec. 10, 2010.
For stocks that are subject to the circuit breaker program, trades will be broken at specified levels depending on the stock price:
- For stocks priced $25 or less, trades will be broken if the trades are at least 10 percent away from the circuit breaker trigger price.
- For stocks priced between $25 and $50, trades will be broken if they are 5 percent away from the circuit breaker trigger price.
- For stocks priced more than $50, the trades will be broken if they are 3 percent away from the circuit breaker trigger price.
Where circuit breakers are not applicable, the exchanges and FINRA will break trades at specified levels for events involving multiple stocks depending on how many stocks are involved:
- For events involving between five and 20 stocks, trades will be broken that are at least 10 percent away from the "reference price," typically the last sale before pricing was disrupted.
- For events involving more than 20 stocks, trades will be broken that are at least 30 percent away from the reference price.
On May 6, the markets only broke trades that were more than 60 percent away from the reference price in a process that was not transparent to market participants. A list of 'winners' and 'losers' created by this arbitrary measure has never been made public. By establishing clear and transparent standards for breaking erroneous trades, the new rules should help provide certainty in advance as to which trades will be broken, and allow market participants to better manage their risks.
In an article that appeared on the Wall Street Journal on the eve of the anniversary of the 2010 'flash crash', it reported high-frequency traders are now less active in the stock market. In a separate article in the journal, it described trades by high-frequency traders has decreased to 53% of stock-market trading volume, from 61% in 2009. Former Delaware senator Edward E. Kaufman and Michigan senator Carl Levin published an op-ed in the New York Times on the one-year anniversary of the Flash Crash, sharply critical of what they perceive to be the SEC's apparent lack of action to prevent a recurrence.
High-frequency traders move away from the stock market as there has been lower volatility and volume. The combined average daily trading volume in the New York Stock Exchange and Nasdaq Stock Market in the first four months of 2011 fell 15% from 2010, to an average of 6.3 billion shares a day. Trading activities has been declining throughout 2011, with April's daily average of 5.8 billion shares marks the lowest month since May 2008. Decrease of sharp movements in stock prices which were frequent during the period from 2008 to the first half of 2010, can be seen in a decline in the Chicago Board Options Exchange volatility index, the VIX, which fell to its lowest level in April 2011 since July 2007.
The recent volumes of trading activity, to some degree, are regarded as more natural levels than during the financial crisis and its aftermath. Some described those lofty levels of trading activity were never an accurate picture of demand among investors. It was a reflection of computer-driven traders passing securities back and forth between day-trading hedge funds. The flash crash exposed this phantom liquidity. High-frequency trading firms are increasingly active in markets like futures and currencies, where volatility remains high.
Trades by high-frequency traders account for 28% of the total volume in the futures markets, which include currencies and commodities, an increase from 22% in 2009. However, the growth of computerized and high-frequency trading in commodities and currencies has coincided with a series of "flash crashes" in those markets. The role of human market makers, who can match buyers and sellers and provide liquidity to the market, is now more and more played by computer programs. If those program traders pull back from the market, then big "buy" or "sell" orders can lead to sudden, big swings. It increases the probability of surprise distortions same as the equity markets, according to a professional investor. In February 2011, the sugar market took a dive of 6% in just one second. On March 1, Cocoa-futures prices dropped 13% in less than a minute on the IntercontinentalExchange. Cocoa plunged $450 to a low of $3,217 a metric ton before rebounding quickly. The U.S. dollar tumbled against the yen on March 16, falling 5% in minutes, one of its biggest moves ever. According to a former cocoa trader: ' "The electronic platform is too fast; it doesn't slow things down" like humans would. '
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