[24589]
October 8, 2010
TO: ETF (EXCHANGE-TRADED FUNDS) COMMITTEE No. 28-10ETF ADVISORY COMMITTEE No. 42-10
EQUITY MARKETS ADVISORY COMMITTEE No. 37-10
INVESTMENT COMPANY DIRECTORS No. 23-10
SEC RULES MEMBERS No. 99-10 RE: CFTC/SEC STAFF REPORT REGARDING MARKET EVENTS OF MAY 6, 2010
On September 30, the staffs of the Commodity Futures Trading Commission and the Securities and Exchange Commission issued a report of their findings regarding the market events of May 6, 2010. [1] Based on an analysis of market data and interviews with market participants and exchanges, the report concludes that the events of May 6, driven by a confluence of macro-economic news events and market participant behaviors, are best described in terms of two liquidity crises– one at the broad index level and one at the individual stock level. The report, which is summarized below, identifies a number of “lessons learned” but does not offer any new policy recommendations. It suggests that May 6 was the result of the behavior of market participants and not the current market structure.
I. Trading Activity on May 6
The report explains that May 6 started as an “unusually” turbulent day for the markets because of unsettling political and economic news concerning the European debt crisis. This negative market sentiment coincided with an increase in the number of volatility pauses on the New York Stock Exchange (“NYSE”), an increase in the S&P volatility index, a decrease in yields of ten-year Treasuries, a drop in the Dow Jones Industrial Average, and a significant drop in liquidity in the E-Mini S&P 500 futures contracts (“E-Mini”) and S&P 500 SPDR (“SPY”). The report states that, against this backdrop, a large fundamental trader entered an order to sell 75,000 E-Mini contracts (“parent order”) using an algorithm programmed to interact with trading volume, without regard to price or time.
According to the report, the liquidity demand from the fundamental trader’s parent order was initially absorbed by high frequency traders (“HFTs”), fundamental buyers, and other intermediaries in the futures markets. As cross-market arbitrageurs interacted with the order, they began to transfer some of the selling pressure from the order to the equities markets. The fundamental trader’s algorithm responded to the increased volume produced by these intermediaries by increasing the rate at which it was sending sell orders into the market to satisfy the parent order.
A. Liquidity Crisis in the E-Mini
The report explains that the resulting combined selling pressure from the algorithm and market participants drove the E-Mini and SPY down three percent in four minutes. The report describes a “hot potato” volume effect, in which HFTs began to quickly buy and then resell contracts to each other, rapidly passing the same positions back and forth as buy-side market depth plunged to less than one percent. [2] The rapid decline in price and liquidity triggered a five-second regulatory trading pause, after which prices began to stabilize as selling pressure in the E-Mini was reduced and buy-side interest increased, returning the E-Mini and SPY to their earlier levels.
During the futures market decline, the fundamental trader’s algorithm sold 35,000 E-Mini contracts while all fundamental sellers and buyers combined sold and bought E-Mini contracts for a net imbalance of 30,000 contracts. As the futures market rose, the fundamental trader’s algorithm executed the remaining 40,000 contracts in the parent order.
B. Liquidity Crisis in Individual Stocks
According to the report, as the broad market E-Mini and SPY recovered, many individual stocks and exchange-traded funds (“ETFs”) experienced extreme price fluctuations. These disruptions were caused by automated trading systems, used by many liquidity providers, temporarily pausing in response to the sudden price declines observed in the futures market to allow traders and risk managers to assess market conditions. Based on their risk assessments, the report states that some liquidity providers “widened their quote spreads, others reduced offered liquidity, and a significant number withdrew completely from the markets.” Additionally, the report states that many internalizers, acting as over-the-counter market makers, began routing most of their retail order flow directly to the public exchanges instead of internalizing them. [3] Thus, even though prices had begun to recover in the futures markets, sell orders placed for some individual stocks and ETFs found reduced buying interest, putting further pressure on the remaining liquidity and leading to further price declines. [4] The resultant complete evaporation of liquidity in some securities and ETFs resulted in trades being executed at predefined trading limits, or “stub quote” prices.
The report concludes that the severe price dislocations were fleeting. During the 20 minute period between 2:40 p.m. and 3:00 p.m., however, over 20,000 trades across more than 300 stocks and ETFs were executed at prices sixty percent or more away from their 2:40 p.m. prices. These trades were later canceled by the exchanges and Financial Industry Regulatory Authority.
II. Lessons Learned
The report identifies a number of lessons from May 6 including the following:
- The automated execution of a large sell order can trigger extreme price movements under stressed market conditions, quickly eroding liquidity and resulting in disorderly markets.
- High trading volume is not necessarily a reliable indicator of market liquidity, particularly in times of significant volatility. [5]
- Regulators must pursue a harmonized regulatory approach that takes into account cross-market trading activity, particularly with respect to index products.
- Many market participants employ their own versions of a trading pause, based on different combinations of signals, to manage risk. For example, according to the report, data integrity is the primary factor in a market maker’s decision as to whether, when, and how to provide liquidity. A liquidity crisis can develop if market participants withdraw liquidity at the same time. This can be effectively countered by a trading halt which provides time for market participants to evaluate their strategies and algorithms to reset their parameters.
- Uncertainty regarding whether trades will be broken can affect market participants’ trading strategies and willingness to provide liquidity. The report suggests that at least half of all broken trade share volume was due to retail customer sell orders because internalizers were the sellers for almost half of all broken trade share volume. [6]
- Fair and orderly markets require “robust, accessible, and timely market data.” The report notes that NYSE transaction information experiences delays in dissemination to the Consolidated Quotation System and Consolidated Tape System feeds but these delays did not cause the extremely volatility in prices seen on May 6 and were not the result of manipulative activity. The report states that the SEC staff will be working with exchanges to explore trading practices for any unintentional or abusive conduct that may cause such systems delays and thereby interfere with fair and orderly price discovery.
Heather L. Traeger
Associate Counsel
endnotes
[1] See Findings Regarding the Market Events of May 6, 2010, Report of the Staffs of the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues, September 30, 2010, available at http://www.sec.gov/news/studies/2010/marketevents-report.pdf.
[2] The report finds that the interviewed HFTs did not follow a pattern of uniform conduct on May 6. Some exited the market but others remained. Overall, HFTs did not expose themselves to significant risk by taking a substantial position – buying only about 200 additional contracts net during the most intense period of the price decline.
[3] Internalizers tend to use their own capital to trade opposite of retail customers.
[4] The report also indicates that much of the liquidity in ETFs is provided by market professionals, such as market makers and HFTs, who tend to quote at and around the inside of the market. Thus, ETFs may not have the same level of resting liquidity as large-cap stocks to counter extreme price volatilities.
[5] The report concludes that the “Liquidity Replenishment Points,” or volatility pauses, on the NYSE did not cause or create the liquidity crisis on May 6. The report also concludes that the “self-help” declarations by several trading centers, permitting them to bypass the quotations of an exchange that is experiencing a systems problem, did not directly contribute to the imbalances between liquidity supply and demand but may have contributed to the general concerns among market participants about abnormal trading and data reliability.
[6] The report reveals that one large internalizer (as a seller) and one large market maker (as a buyer) were party to over fifty percent of the share volume of broken trades, and were counterparties to each other for more than half of this volume.