Rob Daly: The Telltale Trade

Someone owes high-frequency traders everywhere an apology. After the events of the May 6 Flash Crash, almost everyone believed that high-frequency traders on the US cash equities markets were responsible for causing the Dow Jones Industrial Average (DJIA) to plummet nearly 1,000 points in a matter of minutes, and forcing approximately 300 issues to trade at stub-quote prices.

Thanks to the report recently released jointly by the US Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC), the world knows that what caused the Flash Crash was in fact the complete opposite of the general consensus at the time of the event.

It didn’t start with nefarious plots by high-frequency traders that later infected the US futures markets. Instead, regulators attribute the day’s events to a trade by a fundamentals trader at asset manager Waddell & Reed, who tried to unload 75,000 E-Mini S&P 500 contracts in a space of 20 minutes using an unsophisticated volume-driven algorithm.

Once the trade hit an already skittish market—thanks to the fears about Greek sovereign debt—things began rolling downhill fast. High-frequency traders absorbed as much of the new liquidity as they could before clearing their books. However, it was too late, as the equities and exchange-traded fund (ETF) traders stepped back from their trading once they saw the imbalance between their prices and those of the E-Mini contracts. Trade internalizers also selectively started to route retail market orders to the exchanges rather than commit their own capital, further accelerating the market’s drop.

There are many lessons to learn from the SEC–CFTC report. One surprise is that the regulators did not take the opportunity to make further regulatory recommendations. How could they? Between the industry-wide circuit-breaker pilot program and the proposed consolidated audit trail (CAT), there is not much more they can do to eliminate future flash crashes.

The cause wasn’t a systemic issue; it simply was an inopportune trade made when the trader didn’t know the full depth of the market. It could have happened to anyone.

Yet, there is something to say about the wisdom of trying to push through such a large order in such a short amount of time using a fire-and-forget algorithm. According to the report, the sell algorithm did not take in account the price or timing of the E-Mini trades. It just looked for 9 percent of the transacted volume that occurred in the previous minute. In a down market, that algorithm would quickly lead to a major market imbalance.

The first thing that sprung to mind when I read that description was The Sorcerer’s Apprentice segment from Walt Disney’s Fantasia, where one well-meaning act cascades into a deluge of trouble.

I wonder how many risk management systems would have had the ability to identify the knock-on effects of such a trade. Judging from the fallout from May 6, not many. Then again, what responsibility does a trading firm have for the results of its trades if there was no premeditated malfeasance? Poor timing isn’t a crime.

Unless regulators plan to start licensing trading algorithms and their use, flash crashes will be the price the market pays for improved efficiency and interconnectedness. Hopefully the market-wide circuit-breakers strategy will work and arrest any future runaway markets.