Fragmentation of U.S. Equity Markets Worsened Plunge
Representative Paul Kanjorski speaks during a hearing on Capitol Hill in Washington. Photographer: Alex Wong/Getty Images
A “mismatch of liquidity,” selling in futures and exchange-traded funds that fed into stocks and the use of market orders turned an orderly decline into a rout on May 6, a report by federal regulators said.
The Securities and Exchange Commission and the Commodity Futures Trading Commission said in a joint report today that they found no evidence that mistaken orders, terrorism or computer sabotage led the drop, which briefly sent the Dow Jones Industrial Average down 998.5 points. The SEC earlier proposed rules to halt trading in individual shares that swing more than 10 percent within 5 minutes to keep the selloff from recurring.
While the study stops short of assigning blame, its findings support a conclusion that conflicting rules on as many as 50 U.S. market centers fueled a chain reaction of selling that helped erase $1 trillion in stock value. Regulators are still investigating the plunge, which spurred congressional hearings and the issuance of subpoenas last week.
“In the U.S. securities market structure, many different trading venues, including multiple exchanges, alternative trading systems and broker-dealers all trade the same stocks simultaneously,” the report said. “Disparate practices potentially could have hampered linkages among some of these trading venues and led to fragmented trading.”
1987 Crash
The breakdown highlighted how trading in U.S. markets has changed in the past quarter century. During the 1987 crash, most trading in U.S. stocks was handled by humans and the NYSE was dominated by firms that conducted share auctions to match buyers and sellers. Now, automated computer strategies that seek executions in less than a millisecond account for 60 percent of trading volume on all markets, according to Tabb Group LLC, a New York-based research firm.
The Dow average fell as much as 9.2 percent on May 6, its biggest tumble since the crash of 1987, before closing down 3.2 percent. The Standard & Poor’s 500 Index fell 79 points in the 46 minutes after 2 p.m. and companies such as Accenture Plc and Exelon Corp. fell to pennies before rebounding minutes later. Those trades were later canceled.
Regulators are focusing on six aspects of the selloff, including whether declines in stocks, ETFs and futures on the Standard & Poor’s 500 Index spread among each other. A “generalized severe mismatch in liquidity,” possibly worsened by the withdrawal of orders by electronic market makers, and stub quotes, or offers to buy securities for pennies that are never supposed to be used, may have extended the decline.
Canceled Orders
More than 70 percent of the securities whose retreats triggered orders cancelations were equity ETFs, the study found. Since funds tracking bonds experienced smaller drops, the losses probably reflected decreases in component stocks. A majority of ETFs have their primarily listing on NYSE Arca, a venue that Nasdaq and Bats Exchange said had data slowdowns on May 6, through a procedure called “self-help.”
The agencies will determine “whether the declaration of ’self-help’ against NYSE Arca by other exchanges may have impacted NYSE Arca-listed stocks generally and ETFs in particular,” it said. “The loss of access to NYSE Arca’s liquidity pools may have had a greater impact on market liquidity and trading for ETFs.”
LRP Role
Absent from the report is a finding that the NYSE’s program for slowing the market, so-called liquidity replenishment points in which trading is switched to manual auctions, widened stock swings. Rapid-fire price changes trigger the LRP auctions, potentially encouraging electronic orders to flow to other exchanges with few if any offers to buy shares, said Larry Leibowitz, NYSE’s chief operating officer, on May 6.
“Some have suggested that LRPs exacerbated price volatility on May 6 by causing a net loss of liquidity as orders were routed to other trading venues,” the report said. “If accurate, this potentially could cause some NYSE securities to decline further than the broad market decline. Others believe that the LRP mechanism served to attract additional liquidity that helped soak up some of the excess selling interest. We are analyzing the effect of the LRPs closely.”
Staff members of the SEC and CFTC compared hundreds of millions of records from May 6 totaling as many as 10 trillion bytes of computer data, it said. There were more than 17 million trades between 2 p.m. and 3 p.m. and 10.3 billion shares of NYSE stocks changed hands. By contrast, 600 million shares traded on the Big Board during the crash of 1987, according to the report.
Drying Up
The report cites evidence that buying interest began to dry up as the selloff worsened in the 2:30 p.m. to 3 p.m. interval. Widening bid-ask spreads for E-mini futures, swings in volume from second to second and the behavior of traders who facilitate trading in futures markets, known as liquidity providers, suggest that demand decreased during the period, it found.
“Starting at approximately 2:35 p.m. liquidity providers began limiting their trading activity” in the Chicago Mercantile Exchange market for E-mini contracts, it said. “By 2:45:28 p.m., liquidity providers accounted for 46 percent of all transaction sides, lower than their participation percentage between 2:30 p.m. and 2:34 p.m. By 3 p.m., the liquidity providers accounted for 41 percent of transaction sides.”
Echoing the congressional testimony of CFTC Chairman Gary Gensler on May 11, the report cited sales of S&P 500 E-mini contracts by a single trader starting at about 2:32 p.m. on the day of the plunge. The trader “sold on the way down” and made up 9 percent of the volume during the period, the report said.
Order Book
“Data from the CME order book indicates that, although trading volume in the E-mini S&P 500 futures was very high on May 6, there were many more sell orders than there were buy orders from 2:30 p.m. to 2:45 p.m.,” the report said. “Considerable selling pressure at this vulnerable period in time may have contributed to declining prices in the E-mini S&P 500 and other equivalent products such as the SPY,” or the SPDR S&P 500 Trust ETF, it said.
SEC Chairman Mary Schapiro and executives from the biggest exchanges, including NYSE Euronext and Nasdaq OMX Group Inc., agreed that all venues need uniform halts to shut down trading during investor panics. Circuit breakers proposed with the Financial Industry Regulatory Authority would be triggered in all markets by gains or declines of 10 percent over 5 minutes in S&P 500 companies, according to an e-mailed statement today.
Market Orders
Instructions to sell stock at the available price known as market orders, as well as stop-loss commands that “turn into market orders” when prices are falling, may have worsened declines in the broader market. They could be banned or more strictly regulated, the agencies wrote.
“Some of the most disturbing executions on May 6 likely resulted from the use of market orders.” These are popular with individuals, “and it is possible such investors may have been on the losing side of a number of these trades,” the report said.
The SEC and CFTC face pressure to show they have a grip on increasingly fragmented markets dominated by computerized trading of stocks and futures. Representative Paul Kanjorski, who leads the House panel, called hearings last week to scrutinize whether technology and competition for New York-based NYSE and Nasdaq contributed to the free fall in stock prices.
“As old trading methods have given way to modern techniques, the rules governing our market architecture have lagged behind,” said Kanjorski, a Pennsylvania Democrat. “The markets were hardly fair or orderly.”
The role of proprietary speculators who base trades on mathematical algorithms was left unanswered in the report. Delaware Senator Ted Kaufman, a Democrat, asked the SEC and CFTC to tell Congress whether “major banks employ algorithmic trading practices that represent potential systemic risks to the markets” in statements the day after the plunge.
“We are also considering whether initiatives are warranted to address destabilizing short-term strategies, to the extent that they contributed to the May 6 market disruption,” the report said. “If they contributed significantly to the precipitous decline, however, we must consider whether additional regulatory requirements are necessary.”
To contact the reporter on this story: Jesse Westbrook in Washington at jwestbrook1@bloomberg.net; Nina Mehta in New York at nmehta24@bloomberg.net.
To contact the editor responsible for this story: Nick Baker at nbaker7@bloomberg.net.
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