This article appeared in Corporate page of The Edge Malaysia, Oct 30 – Nov 6,2010

The Crash of 2:45 – An Autopsy

By Jasvin Josen
High Frequency Traders. Flash Trades. Algorithmic Trading. – these uncommon phrases have
suddenly become familiar in the news since the May 6 “flash crash” that occurred at 2:45
pm and ended twenty minutes later.

It later turned out that the crash was actually sparked by a $4.1bn sale of stock index futures
by a single institutional investor. On Oct 1, the U.S. Securities and Exchange Commission
(SEC) and the U.S. Commodity Futures Trading Commission (CFTC) provided an in-depth
analysis of what actually happened that day, in a 104 page report (referred as “the Report”)

This article will describe the chronology of events which brought on the biggest one-day
point decline (998.5 points) on an intraday basis, in Dow Jones history.

9:00 A.M.

On the morning of May 6, 2010, New Yorkers woke up to adverse news on the European
debt crisis that had been looming all afternoon across Europe. The market was demanding
higher premiums for bearing additional risk. CDS premiums rose on some European
sovereign debt while the Euro was suffering a downward pressure.

1:00 P.M.

It is no surprise that the despair spread swiftly to the U.S. markets. By 2.30 pm, the S&P 500
Volatility Index (VIX) increased 22.5%, while investors shifted towards “quality” investments
such as gold and Treasuries. Selling pressure had pushed the Dow down about 2.5%.

The risk began to manifest itself in individual equities on the New York Stock Exchange
(NYSE) and Liquidity Replenishment Points (LRPs) began to trigger far above average levels.
LRPs are mini circuit breakers that the NYSE applies to individual equities during unusually
volatile markets. These are not the standard circuit breakers that were put in by the SEC
after the 1987 Black Monday crash - that would have required a 10% downward move in the
Dow Jones.
When a share price falls rapidly (1% to 5%; the limit varies for different stocks and daily
trading volume), the LRP kicks in to temporarily convert the trading of a stock from an
automated market to a manual one. Trading on the NYSE for that stock will “go slow” and
automatic executions will cease for a time period ranging from a fraction of a second to a
minute or two, to allow the manual market to contribute additional liquidity before
returning to an automated market.
According to the Report, that day, between 2:30 p.m. and 3:00 p.m., more than 1000
securities triggered LRP events lasting more than 1 second, compared to a “normal” day
average of only 20-30 such events.
At about the same time, the E-Mini S&P 500 futures (E-mini), the most active stock index
instrument plunged by 55% from early-morning levels. Another very active stock index
instrument, the S&P 500 SPDR exchange traded fund (“SPY”), also declined by 20%. Chart 1
and Chart 2 show the volume and price movements of the E-mini and SPY ETF that day.

The E-Mini is often accepted as the primary price discovery product for the S&P 500 Index.
In other words, investors perceive these future contracts to transmit information into prices
for the S&P 500 index.

Chart 1 : E-Mini Volume and Prices on May 6, 2010

Source: Findings Regarding the Market Events of May 6, 2010, by SEC and CFTC, Sep 30, 2010

Chart 2: SPY ETF Volume and Prices on May 6, 2010

Source: Findings Regarding the Market Events of May 6, 2010, by SEC and CFTC, Sep 30, 2010

2.32 P.M.
Against the setting of unusual high volatility and thinning liquidity, at 2:32 p.m., a large
“Seller”, a mutual fund complex initiated a program to sell 75,000 E-Mini contracts (valued
at approximately $4.1 billion) as a hedge against the risk of a market downturn.

Generally, a customer makes a choice of how much human judgement is involved in

executing a large trade. He could engage an intermediary to manage the position. He could
also choose to manually enter orders into the market. Or, he could execute a trade via an
automated execution program. The algorithm in the program will have in-built conditions to
execute trades according to price, time and/or volume.

The Seller chose the third option. Its automated execution algorithm (Sell Algorithm) was
programmed to feed orders into the June 2010 E-Mini market to target an execution rate of
9% of the previous minute trading volume, but without regard to price or time. The Sell
Algorithm executed the sale in just 20 minutes. Without doubt, it appears that the Seller
wanted the order to be completed as quickly as possible, at any price. Or could it be an
erroneous condition in the algorithm? The Report falls short in probing into this aspect.
The Report identifies High-Frequency Traders (HFTs) and intermediaries (i.e. market makers
and brokers) to be the likely buyers of the initial batch of orders submitted by the Sell
Algorithm. As a result, these buyers built up temporary long positions.

HFTs are trading firms that use high speed systems to monitor market data and submit large
numbers of orders to the markets. They utilize quantitative and algorithmic methodologies
to trade with the exchange. We will explore this subject further in the next article.

2.41 P.M.
Before the 75,000 contracts were fully taken up, the HFTs then aggressively began to sell E-
Mini contracts in order to reduce their temporary long positions. This is consistent with the
HFTs’ typical practice of trading a very large number of contracts, but not accumulating a
significant inventory in either direction.
As they quickly proceeded to sell their contracts to the market, they only found other HFTs,
who in turn bought and quickly resold the contracts, creating a “hot potato effect” that
created huge volume.
A very useful lesson pointed out by the Report - Especially in times of significant volatility,
high trading volume is not necessarily a reliable indicator of market liquidity.
The Sell Algorithm, which had not completed the sale of the 75,000 E-mini contracts,
responded to the increased volume by increasing the rate at which it was feeding the orders
into the market, even though the initial orders were possibly not yet fully absorbed.
In the five minutes before 2:45 p.m., prices of the E-Mini fell by more than 5% and prices of
SPY declined over 6%. Buy-side depth was already a serious issue.

2.45 P.M.
Trading on the E-Mini was paused for five seconds when the Chicago Mercantile Exchange
(“CME”) Stop Logic Functionality was triggered. During that split-second, sell-side pressure
in the E-Mini somewhat eased and buy-side interest returned. When trading resumed at
2:45:33 p.m., prices stabilized and shortly thereafter, the E-Mini began to recover, followed
by the SPY.
The Sell Algorithm continued to execute the sell program until about 2:51 p.m. as the prices
were rapidly rising in both the E-Mini and SPY.
The second liquidity crisis occurred in the equities markets. The Report confirmed that many
market liquidity providers temporarily paused trading in reaction to the sudden price
declines observed in the E-mini and SPY markets. Based on their respective individual risk
assessments, some market makers widened their quote spreads, others reduced offered
liquidity, and a significant number withdrew completely from the markets.
The severe dislocations observed in many securities were short-lived. 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.

3.00 P.M.
By this time, most securities had reverted back to trading at prices reflecting true consensus
values.

4.00 P.M.
After the market closed, the exchanges jointly agreed to cancel (or break) trades that were
more than 60% away from their 2:40 p.m. prices.
As liquidity completely evaporated in a number of individual securities, some participants
with instructions to sell (or buy) found no immediately available buy interest (or sell
interest). This resulted in trades being executed at irrational prices as low as one penny or
as high as $100,000, as a result of so-called “stub quotes”.

When a market maker’s liquidity has been exhausted, it may (on some markets) submit a
stub quote – an offer to buy or sell a given stock at a price so far away from the prevailing
market that it is not intended to be executed, such as a penny (buy order) or $100,000 (sell
order). This is to comply with its obligation to maintain a continuous two-sided quotation.

Conclusion

The next day, Tim Geithner, Treasury secretary, spoke to Mary Schapiro, chairman of the
SEC, and other regulators to discuss the issue. “We cannot allow technological problems,
regulatory loopholes or human blunders to spook the markets and cause panic.”

In the next article, we explore the lessons learnt from this crash and indeed if it is possible
to avoid spooking the markets again.