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SEC and CFTC Issue Report on May 6 Flash Crash

On Friday, the SEC and CFTC issues a joint report relating the findings of their study of the May 6, 2010 "Flash Crash," an unprecedented acute and sudden disappearance of meaningful prices for many major exchange-listed stocks in the middle of the May 6 trading day.  This report builds upon the initial analyses of May 6 performed by the staffs of the Commissions and released in the May 18, 2010.  The report lays out an excellent summary of the conditions, triggers, and reactions that resulted in the Flash Crash.  

The report's findings are presented in four sections:

  1.  Nature and sources of the selling pressure at various points during the day on May 6.
  2. Effect selling pressure had on key market participants, focusing in particular on their withdrawal from the markets and the consequent evaporation of liquidity.
  3. Additional factors that may have had a role in the events of the day.
  4. Detailed examination of the aggregate order books for selected stocks and ETFs, illustrating how reductions in liquidity led some securities to trade at absurd prices.

Though not conclusively affixing blame or causation on any one group of market participants, individual actors, or any particular trading activity or system, the report does set forth some valuable lessons learned from the event.  

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.

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.

The report provides an interesting post mortem of an heretofore unique market phenomenon. 

The full text of the joint report is available at:  http://www.sec.gov/news/studies/2010/marketevents-report.pdf

The preliminary report is available at:  http://www.sec.gov/sec-cftc-prelimreport.pdf