Flash Crash Mystery Solved
Below are portions of a comment letter submitted by R.T. Leuchtkafer to the SEC on April 16, 2010, just 3 weeks before the flash crash. The second paragraph in the excerpt below, unknowingly describes exactly how the flash crash was started. The letter goes on to alert the SEC on the dangers of High Frequency Trading (HFT), phantom liquidity and other concerns.
Our exhaustive analysis of the May 6, 2010 Flash Crash included:
- processing trillions of exchange quote, trade and order book records for stocks, options, and futures on May 6th and other trading days back to 2005 and days since.
- matching up the actual 6,438 trades (75,000 contracts) executed by Barclays for Waddell & Reed to the 147,577 trades executed in the CME June 2010 eMini during that time.
- drawing from extensive interviews with authors of academic and regulatory papers on the Flash Crash.
- conversations with dozens of traders, programmers, investigative jouralists, government officials in the U.S. and abroad, anonymous callers, and "people familiar with the matter" since June 2010.
- finding and studying similar crashes in the eMini and crude oil and thousands of other anomalies.
From this, we were able to zero in on the ignition point, or starting time of the crash: 14:42:44. That is the moment when one or more large HFT "market makers" hit their limit of long positions in the eMini Futures (ES.M10), and reversed out - "readjusted their position". Immediately. That aggressive act sucked out a significant amount of liquidity and caused thousands of trading instruments (stocks, options, indexes, futures) to reprice, which severely overloaded all trading systems processing market data (peak message traffic set a record at that time, which was not exceeded for the balance of the day). Overloaded systems caused bad, delayed, and unexpected pricing to appear, which caused other algos and traders to stop trading, removing any remaining liquidity. We know the Waddell & Reed algo practically ceased trading shortly before the 600 point slide in the Dow Jones Industrial Average; selling a mere 1000 contracts in small lots (averaging 6 contract per trade), all on the offer side. No Virginia, the Barclay's algo used by Waddell & Reed did not sell indiscriminately without regard to time or price: it didn't take liquidity either. That was the work of HFT. In short:
High Frequency Trading caused the Flash Crash. Of this, we are sure.
If the above isn't enough damning evidence, in the paper Moore’s Law vs. Murphy’s Law dated March 19, 2013 co-authored by Andrei Kirilenko, the former CFTC chief economist and principal author of the final SEC flash crash report (page 11), finally agrees:
...After buying the E-mini for about 10 minutes, high frequency traders reached their critical inventory levels and began to quickly and aggressively unwind their long inventory at a key moment when liquidity was sparse, adding to the downward pressure. High frequency traders rapidly passed contracts back and forth, contributing to the “hot potato” effect that drove up trading volume, exacerbating the situation. Meanwhile, cross-market arbitrage trading algorithms rapidly propagated price declines in the E-mini futures market to the markets for stock index exchange-traded funds like the Standard & Poor’s Depository Receipts S&P 500, individual stocks, and listed stock options. According to the interviews conducted by the SEC staff, cross-market arbitrage firms “purchased the E-Mini and contemporaneously sold Standard & Poor’s Depository Receipts S&P 500, baskets of individual securities, or other equity index products.” As a result, a liquidity event in the futures market triggered by an automated selling program cascaded into a systemic event for the entire U.S financial market system. As the periods during which short-term liquidity providers are willing to hold risky inventory shrink to minutes if not seconds, Flash-Crash-type events—extreme short-term volatility combined with a rapid spike in trading volume—can easily be generated by algorithmic trading strategies seeking to quickly exploit temporarily favorable market conditions.
That key moment in time was 14:42:44.
Finally, we can close the books on investigating the cause of the flash crash.
Note to journalists.
The HFT lobby will vehemently deny any blame for causing the flash crash and will use a number of straw man arguments, eventually enlisting the SEC final flash crash report which named Waddell & Reed as the cause (W&R). Here are some key points to remember:
- Always ask for data used to back up any claim. You will find a lot of people are long on talk, woefully short on data. Data is difficult to obtain and takes a lot of expertise to work with: use that to separate the wheat from the chaff.
- The SEC publicly stated numerous times that it took them 5 months just to receive and organize the vast amount of market data. 5 months from May 6th is October 6th, yet they published their report on October 1st. When did they have any time for analysis?
- W&R used Barclays to execute the algo (a fact not mentioned in any SEC report).
- The regulators (CFTC) first interviewed the Barclay team that executed the W&R trades on October 14, 2010 - yet published the final flash crash report 2 weeks earlier, on October 1, 2010. Why this has never been mentioned in the media is a mystery.
- Barclay's algo only sold at the offer, never crossing the bid-ask spread during the crash: it was entirely passive, and did not move the order price lower once entered. This type of passive algorithm cannot cause a market crash on its own.
- Barclay's algo only sold about 1000 contracts during the entire 600 point slide in the DJIA. It did not accelerate selling as the market began to drop. To claim otherwise is simply untrue.
- Barclay's algo sold heavily after the eMini circuit breaker ended and the market had bottom: a period of maximum chaos, severely delayed feeds and minimum liquidity. Yet market prices climbed.
- The SEC final flash crash report incorrectly uses the word liquidity 249 times in 89 pages. It is worthwhile reading about this monumental logic error.
- Barclay's and W&R gave the actual trade executions to Nanex for analysis and we were able to match up those trades to the CME time and sales so we have a true and accurate picture of how the algo executed. We know exactly which trades came from W&R and an exact picture of how the market looked when each one executed.
This is a very complex subject and lobbyists will use that to bamboozle you. Feel free to ask questions at the email below. Also, be sure to watch this award winning documentary (Money & Speed) which captures Eric Hunsader of Nanex on film formulating what turned out to be, the actual cause of the flash crash.