A mutual fund’s routine effort to hedge against losses helped set off a chain of events that turned an orderly selloff on May 6 into a crash that erased $862 billion in U.S. equity value in less than 20 minutes, according to two people with direct knowledge of regulators’ findings.
Waddell & Reed Financial Inc. sold CME Group Inc.’s E-mini futures on the Standard & Poor’s 500 Index, spooking traders nervous because of the European debt crisis, the Securities and Exchange Commission and Commodity Futures Trading Commission have concluded, according to the people, who declined to be identified because the findings haven’t been released. Their report on the crash, which briefly sent the Dow Jones Industrial Average down 998.50 points, may be released as early as today.
“Every day, markets are capable of handling large trades,” said Lawrence Harris, a finance professor at the University of Southern California in Los Angeles and a former chief economist at the SEC. Any large transaction on May 6 could “have been the unfortunate trade that broke the camel’s back.”
Regulators are facing pressure from investors to explain whether trading rules have failed to keep pace with markets that now handle order executions in millionths of a second. SEC Chairman Mary Schapiro is trying to protect investors in a fragmented U.S. stock market while maintaining liquidity -- the ease with which investors can buy and sell shares -- on venues dominated by firms that profit from computerized trading.
A joint SEC-CFTC report on May 18 said the crash may have been exacerbated by trading rules that differed from venue to venue. In June, exchanges implemented circuit breakers that pause trading in more than 1,300 securities during periods of volatility to prevent selling from snowballing. They have also adopted uniform policies for canceling trades and are eliminating stub quotes, or bids and offers to execute at prices far away from the stock’s last sale.
Lawmakers such as Sen. Ted Kaufman, a Democrat from Delaware, have asked if the high-frequency firms that have supplanted specialists and market makers with strategies that transact thousands of shares a second destabilized trading by withdrawing their liquidity when they were needed most.
Schapiro said earlier this month that regulators should examine increased obligations for market makers providing orders to buy and sell stocks. The SEC and CFTC found in their initial report about May 6 that electronic trading firms supplying bids and offers reined in their activity, increasing the “mismatch of liquidity” and potentially exacerbating the decline.
Regulators said in that May 18 report they were examining the protocols that dictate how exchanges route orders between one another and curbs called liquidity replenishment points on the New York Stock Exchange. The latter mechanisms, which operate only on NYSE, slow down trading so market makers can oversee quick auctions that aggregate buy and sell demand.
While the NYSE Euronext-owned exchange said the safeguards prevented it from canceling orders on May 6, executives at New York-based Nasdaq OMX Group Inc. and Bats Global Markets in Kansas City, Missouri, have said they caused the marketplace to become less coordinated in a time of stress. Exchanges canceled almost 20,800 trades on May 6 that were at least 60 percent away from the market price when the plunge began.
The SEC and CFTC said in the May 18 report that they were also exploring possible linkages between price declines in equity index futures, exchange-traded funds and individual securities and the “extent to which activity in one market may have led the others.” Equity markets continued to slide after futures began improving, with stocks such as Accenture and Exelon Corp. trading at pennies when they executed against stub quotes intended to meet a regulatory obligation.
‘Didn’t Behave Robustly’
“Linkages between stock markets didn’t behave robustly that day,” Mike Bleich, chief executive officer of Scout Trading LLC, a market-making firm in New York, said yesterday. He was previously head of liquidity strategy at Barclays Plc in New York, where he also ran an electronic market-making group. “If the linkages were better, the result might not have been as severe,” he said.
Waddell & Reed will not be identified by name in the SEC and CFTC report, according to two people familiar with the matter. The document also won’t make any policy recommendations, they said. SEC spokesman John Nester declined to comment.
“I’m not sure it’s appropriate to comment on a report that doesn’t name us specifically, but it’s clear we were one of many traders that day,” said Roger Hoadley, director of communications at Overland Park, Kansas-based Waddell & Reed. “We were merely trying to manage downside risk in our portfolios.”
Waddell & Reed Chief Investment Officer Michael Avery said in a conference call on July 28 that the asset manager’s “ability to use hedging as an effective defensive strategy is constrained by either what appear to be increasingly fragile markets and/or liquidity constraints place on us by the exchanges.” He added: “But so far that has not been an issue.”
About 250 trading firms processed transactions in E-mini S&P 500 futures from 2 p.m. to 3 p.m. New York time on May 6, regulators said in their May 18 report on the rout. One of the largest firms selling the E-mini contract accounted for about 9 percent of volume from 2:32 p.m. until 2:51 p.m., they said. The firm, which wasn’t named, sold the contract short to hedge other positions and “only entered orders to sell,” according to the May 18 report.
“The trader sold on the way down and continued to do so even as the price level recovered,” the report said four months ago. “This trader and others have executed hedging strategies of similar size previously.”
E-mini S&P 500 futures are the largest contract by volume traded on the Chicago Mercantile Exchange, owned by CME Group. Chief Executive Officer Craig Donohue said on June 22 that volume in the June E-mini S&P 500 futures on May 6 was 5.7 million contracts, with about 1.6 million, or 28 percent, trading from 2 p.m. to 3 p.m. New York time. At about 2:45:28 p.m. the contracts declined 12.75 points in half a second when 1,100 were sold by multiple traders, he 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 SPDR S&P 500 ETF Trust, an exchange-traded fund tracking the benchmark measure of U.S. stocks, the May 18 report said.
“All of these markets are closely linked by a complex web of traders and trading strategies,” regulators wrote four months ago. “The precipitous decline in price in one market on May 6 may have influenced a sustained series of selling in other financial markets.”