Could Program Trading Cause Another “Flash Crash?” – Unfortunately the Answer is “Yes”


After five months of analysis, the staffs of the Securities and Exchange Commission and the Commodities Futures Trading Commission have determined that the May 6th Flash Crash was set in motion by a huge sale of S&P 500 futures contracts by a single firm’s computer trading program, which dumped $4.1 billion of the contracts on the market in just 20 minutes, according to “Lone $4.1 Billion Sale Leads to ‘Flash Crash’ in May,” by Graham Bowley of The New York Times; and “How a Trading Algorithm Went Awry,” by Tom Lauricella, Kara Scannel, and Jenny Strassburg of The Wall Street Journal. Some have criticized the report for describing “how” it happened without explaining “why” it happened.

May 6 began as an unusually turbulent day with the markets roiled by the European debt crisis. The Dow was already down 276 points when, at 2:32 p.m., the trading algorithm of a single firm began selling E-Mini Standard & Poor’s 500 futures contracts “without regard to price or time.” This particular trading algorithm is widely used on Wall Street, but is usually tweaked to take into account variables such as trading volume, price changes, and the time allowed to complete a trade. In this case, however, the algorithm did not appropriately respond to such variables.

Over the next 20 minutes, the program sold 75,000 contracts, and the selling accelerated as prices plunged. For comparison, the SEC/CFTC report referenced a similar trade earlier in 2010 that took five (5) hours to complete.

As this initial program selling hit the market, computer-driven high-frequency trading firms created a “hot potato” effect by buying and selling as many as 27,000 contracts in just 14 seconds. In the presence of this high-frequency churning and plunging stock prices, the initial selling firm’s algorithm responded by increasing the selling. Many high-frequency trading firms shut down their systems. Long term buyers were absent. Liquidity dried up; price volatility spiked. Transactions occurred at crazy prices – a few pennies or $100,000 a share.

Exchange traded funds were particularly hard hit, according to a Wall Street Journal article by Ian Salisbury called “Rocky Trade Led To an ETF Pileup.” The SEC/CFTC report said that the lack of liquidity and price volatility in the underlying stocks made it impossible for S&P 500-linked ETF market makers to value the ETFs. As a result their trading dried up and the ETF trades that occurred were often for absurd prices.

The SEC has announced the institution of circuit breakers that would trigger a five-minute suspension of trading on a stock that moves more than 10% in a five-minutes period. In addition, the SEC has said that it is considering limiting the speed of high-frequency trading and the use of “stub quotes.”

But some are dissatisfied with the SEC’s and CFTC’s report. “They didn’t explain why it never happened before and if it is unlikely to happen in the future,” Adam Sussman, director of research at the Tabb Group, was quoted as saying. “In that, it is disappointing.” Joe Saluzzi, co-head of equity trading at Themis Trading, a high-frequency trading firm, was more blunt: “All you got here is five months after the fact, you have an analysis of 15 minutes of trading. If this were to occur again, it would take another five months to figure it out.”

J. Boyd Page, senior partner at Page Perry in Atlanta, which represents investors, said: “The main lesson from all of this is that computer-driven high-frequency trading has had a destabilizing effect on the stock market, it is far from certain that this problem is completely understood, much less fixed, and investors need to take that into account in deciding how to invest their money.”

Page Perry is an Atlanta-based law firm with over 125 years collective experience representing investors in securities-related litigation and arbitration. While past results are not indicative of future success, Page Perry’s attorneys have recovered over $1,000,000 for clients on more than 30 occasions. Page Perry’s attorneys have extensive experience in representing investors in securities matters. For further information, please contact us.