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

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A spokesman for Waddell offered a statement, originally made in May, stating that the company does not believe it was behind the market chaos.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

The mutual fund company, according to the report, used a computer-driven automated strategy to sell E-Minis at any cost, as fast as possible.

In the past, the company had made bets as large in the E-Mini market, but had controlled for price and time, according to the report. Those trades took more than five hours to execute and caused no problems.

But this time, the program completed all its trades in 20 minutes.

High-frequency trades

The report said that many of the sell orders were bought by high-frequency traders, hedge funds and other firms that seek to make profits by exploiting millisecond-long changes in prices. But just as soon as they bought the E-Minis, they turned around and tried to sell them.

Regulators called the cycle of selling a "hot potato" effect. With many more sellers than buyers, the price of the E-Mini rapidly fell.

The effect was quickly mirrored in the actual stock market. Spotting the upheaval in the E-Mini market, financial firms that usually are active buyers and sellers of shares withdrew or severely limited their activities until they figured out what was going on.

With the stock market already sagging, there were far more sellers than buyers for many stocks. With little to no liquidity, trades in some stocks occurred at unfathomable prices - under a penny or at $100,000.

By 2:47 p.m., the Dow had fallen 600 points and was down nearly 1,000 for the day.

Both the E-Mini market and the stock market rebounded, after a mechanism designed to pause trading in E-Minis during extreme volatility triggered.

Soon after, the number of buyers and sellers in the market came back into balance, and markets recovered their losses.

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