An investigation by the two commissions surmised that the reason for the sharp sell-off that led to 8,000 securities and ETFs losing as much as 15% in minutes only to rebound shortly thereafter was an algorithm initiated by a mutual fund to sell 75,000 e-mini contracts as a hedge against market losses.
According to the report, the selling pressure induced by the algorithm led to further selling by high-frequency traders, and as buyers were lacking, the HFTs bought and sold the securities back and forth, causing a ‘hot-potato’ effect.
But several market participants say that the sale by the mutual fund (named as Waddell & Reed in the media) was not the cause of the crash.
Eric Hunsader, chief executive of Nanex, which runs a data-feed platform of all quotes on the exchanges, says the mutual fund algorithm cited in the report is a red herring. Based upon his firm’s research, the fault lies with one trader who bought 3,000 of Waddell & Reed’s contracts and within 50 milliseconds sold them all, breaking through the 10 levels of bid prices that an e-mini contract has. "Whoever made that trade may have been trying to make an impact," says Hunsader.
10 levels
When the 3,000 contracts were sold at the bottom end of the 10-bid level, ETFs and underlying stocks held in the e-mini had to immediately reprice. "It caused an explosion of data that overwhelmed systems that process that data," he adds. "It wasn’t the Waddell & Reed sell decision that caused the crash."
Mary Schapiro, chairwoman of the SEC, has defended the investigation’s claims, maintaining that the commissions had sufficient information to determine the cause. Even if the report is correct, however, why have the SEC and CFTC not named or even alluded to the seller of the 3,000 contracts that busted through the bid levels and caused the data overload?
One head of a trading firm suspects that the SEC and CFTC were under pressure just to come up with some conclusion so they could move on and rethink regulation to quell concerns, and so glossed over that particular sale.
Regardless of who the culprit was, industry participants are hoping that the commissions will narrow in on the hot potato effect. CFTC chairman Gary Gensler highlighted the problems of this back-and-forth selling and buying between high-frequency traders at a conference in Washington, stating that the reason that the e-mini sale order could not be handled was that there were simply not enough parties willing to buy and hold the order for an extended period of time.
Back and forth
"Much of the volume on May 6 was just positions being moved back and forth over a matter of seconds between high-frequency traders and other market makers. This is what our economists refer to as ‘hot potato volume’. For the large trader’s order to actually be absorbed by the market, it had to find fundamental or opportunistic buyers who were willing to hold the position at least for more than a few seconds... The events of May 6 demonstrate that, in volatile markets, high trading volume is not necessarily a reliable indicator of market liquidity," said Gensler.
| "Back-and-forth selling, by creating high volumes, gives an illusion of a liquid market" |
Joe Saluzzi, co-head of equity trading at Themis Trading, hopes that the SEC and CFTC will take the matter of back-and-forth selling seriously. "Back-and-forth selling, by creating high volumes, gives an illusion of a liquid market but these traders are not real investors. If they account for 70% of volumes, then people need to realize that only 30% of volumes are driven by buyers and sellers who are thinking about the stock or options from a fundamental perspective." He compares hot potato trading to circular trading where traders act in coordination to trade in a stock to make the stock appear as if it is heading higher before dumping it. Saluzzi says one of the issues that regulation needs to tackle to prevent trading for trading’s sake is to address rebates.
"Exchanges are trying to increase their market share and to convince traders to use them to trade. They will pay rebates to those that add liquidity to their exchange." He says some shops can make a business simply by collecting rebates from trading frequently. "This model needs to be fixed. Some traders are being paid to add liquidity, but they are not adding liquidity as when it comes down to it they do not want to own the stock. They simply want to trade it back and forth for rebates," says Saluzzi. "This issue is routinely ignored by regulators but it is crucial in establishing stability in the markets."
