ABC's Dan Arnall reports from New York:
In summary, the SEC says that one large trader – identified as KC-based mutual fund company Waddell & Reed by the WSJ and other publications – decided it needed to sell $4.1 billion in futures contracts which were tied to the S&P 500 market value to hedge its positions in the markets to protect its investors.
A previously issued statement from Waddell & Reed addressed the reason for their move: “On May 6th, when the portfolio managers reached the conclusion that the risk of the European sovereign crisis extending to the United States and our financial system was increasing, they decided to reduce the Funds’ equity exposure quickly.”
That kind of order is not necessarily all that hair-raising or unprecedented. But, according to the SEC report, the way they decided to execute the trade was.
The report says there are three ways traders can sell big blocks of shares: Engage an intermediary (have an investment bank sell the futures contracts on their behalf over time), manually enter the sell order themselves (humans watching the market and selling over time) or have a computer do the work (selling the futures contracts into the market based on specific parameters entered).
The report says the large trader on decided to let the computer do the work, pushing through the sell order and specifying only that the selling be 9% of the total trading volume of market for these S&P futures contracts.
That’s where things likely went wrong, according to the SEC. The trader was selling a big block of shares and told the computer to do it fast, without regard to price or time taken into consideration. According to the report, it was the largest trade of its kind since the beginning of the calendar year.
“Only two single-day sell programs of equal or larger size – one of which was by the same large fundamental trader – were executed in the E-Mini in the 12 months prior to May 6,” reads the report.
One of those previous times, it was the same big trader making the sale. “When executing the previous sell program, this large fundamental trader utilized a combination of manual trading entered over the course of a day and several automated execution algorithms which took into account price, time, and volume.”
The report says that during the previous order, it took humans and computers 5 hours to sell the 75,000 contracts; on May 6 the trader’s computers pushed the same volume of shares onto the market in just 20 minutes.
“By our calculations, our trading activity accounted for approximately 1% of the volume traded that day in the e-mini S&P 500 Index futures contract,” said the previously published Waddell & Reed statement. “While we executed a number of trades, the volume was not large relative to the overall depth of the market. We believe that the behavior both of the price of the e-mini and the bid/ask spread on the e-mini also do not suggest that our trades had a disruptive effect.”
The SEC report takes a different tack. It says the trade sparked a flood of selling by high frequency traders in the market for S&P e-mini contracts, triggering other automated sell orders in other securities, snowballing into the massive sell-off which frightened the entire market.
“One key lesson is that under stressed market conditions, the automated execution of a large sell order can trigger extreme price movements, especially if the automated execution algorithm does not take prices into account. Moreover, the interaction between automated execution programs and algorithmic trading strategies can quickly erode liquidity and result in disorderly markets.”
The 104-page Flash Crash Report: http://www.sec.gov/news/studies/2010/marketevents-report.pdf