Report examines May's 'flash crash,' expresses concern over high-speed trading

Oct. 1 (Bloomberg) -- Bart Chilton, a member of the Commodity Futures Trading Commission, discusses today's joint report by the CFTC and the Securities and Exchange Commission about the May 6 computer-driven stock market crash. The report found that the automated sale of stock futures without regard to price and "hot potato" trading by computer-driven firms that briefly created an illusion of liquidity helped trigger the crash, turning an orderly selloff into an $862 billion rout as buy orders evaporated. Chilton talks with Peter Cook on Bloomberg Television's "Street Smart." (Source: Bloomberg)
By Zachary A. Goldfarb
Washington Post Staff Writer
Friday, October 1, 2010; 10:21 PM

On the afternoon of May 6, portfolio managers at Waddell & Reed Financial, a little-known mutual fund company near Kansas City, were growing worried that fears of a European fiscal crisis would spread to the United States, where the stock market was already sagging.

So they decided to make a trade that would limit their losses if the market continued to decline. As is custom these days, they instructed their computers to start an automated program of selling financial contracts that were linked to the value of stocks.

It should have been a blip in the market. Instead, according to government officials, it triggered a torrent of selling that quickly overwhelmed the nation's stock exchanges and sent shares of major companies plummeting in what has since been dubbed the flash crash.

On Friday, federal regulators released a much-anticipated report explaining how the single trade initiated a series of events that led the Dow Jones industrial average to fall more than 600 points in minutes before rebounding. Many other stock indices and individual securities shared the same fate that day. The 104-page report does not name Waddell as the culprit, only mentioning a mutual fund company. But a federal official familiar with the matter, speaking on the condition of anonymity, said it was Waddell.

A spokesman for Waddell offered a statement, originally made in May, stating that the company does not believe it was behind the market chaos.

Vulnerability exposed

The report by the Securities and Exchange Commission and the Commodity Futures Trading Commission made clear that the nation's financial markets were far more vulnerable on May 6 than was previously known and that regulators had failed to keep up with the rapidly increasing size and complexity of markets.

The agencies' findings showed that stock exchanges and regulators have not come to grips with the effect of automated, high-speed trading on the markets. They also showed that a fractured set of rules across different markets added to the confusion about what was really going on. And they underscored how trading in speculative futures markets - and other less regulated electronic markets where firms make bets about risks - can affect underlying stocks.

Regulators have already tried to tackle some of these issues, approving new circuit breakers that would pause trading in stocks and certain index funds if there is a sudden decline or increase in value.

"This report identifies what happened and reaffirms the importance of a number of the actions we have taken since that day," SEC Chairman Mary Schapiro and CFTC Chairman Gary Gensler said Friday in a statement. "We now must consider what other investor-focused measures are needed to ensure that our markets are fair, efficient and resilient, now and for years to come."

Betting against Greece

Federal investigators are still looking into whether wrongdoing played a role in the flash crash. But officials said it appears that Waddell was acting in good faith on May 6.

On that afternoon, the stock market was struggling as concerns spiked about Europe's economy. Traders were betting that Greece might default on its debt, and the euro was plunging. There were far more sellers in the market than buyers.

At 2:32, Waddell decided to sell $4.1 billion worth of financial contracts, known as E-Minis. The E-Minis are linked to the value of the Standard & Poor's 500-stock index, a broad indicator of blue chip stocks. They are traded on an electronic futures market, one of a handful of alternative venues to bet on the direction of the market without buying and selling stocks.

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