Trades Dumped on Exchanges Blamed for Intensifying May 6 Crash

Jamie Selway
“Internalizers pulling back their services and dumping orders on exchanges changes the mix of flow exchanges receive,” said Jamie Selway , a managing director at Investment Technology Group Inc. Source: Archipelago via Bloomberg

Brokerages overwhelmed by plunging prices on May 6 were forced to send sell orders from individuals to public exchanges instead of processing them internally, causing at least 50 percent of the canceled trades that day, according to U.S. regulators.

“Internalizers instead routed orders to the exchanges, putting further pressure on the liquidity that remained in those venues,” the Securities and Exchange Commission and Commodity Futures Trading Commission said in a report released Oct. 1 that detailed the causes of the rout. They did this because of selling pressure from retail customers, an unwillingness to trade and questions about the accuracy of market data given the speed of the decline, the document added.

More than 20,000 trades representing 5.5 million shares were executed at prices 60 percent or more away from levels from before the crash, the SEC and CFTC said. Of the broken transactions, one brokerage and a single market maker accounted for about half of the executions, they added. The firms weren’t identified.

The 104-page report on the crash that briefly erased $862 billion from U.S. shares in less than 20 minutes before they recovered most of their losses explains for the first time the degree of involvement by brokers called internalizers. They usually trade in their own accounts against orders from so-called discount brokerages.

‘Pretty Aberrant’

“Internalizers pulling back their services and dumping orders on exchanges changes the mix of flow exchanges receive,” said Jamie Selway, a managing director at Investment Technology Group Inc. in New York. “When exchanges get orders that are less precisely priced than what they’re used to getting, the results can be pretty aberrant.”

Five months after the plunge spurred calls in Congress for an overhaul of U.S. equities trading, the Oct. 1 report stopped short of giving fresh prescriptions for how to prevent another crash from happening. Instead, regulators honed their original findings to focus on how a single trade in the futures market created panic that bled into stocks, overwhelming human beings and computers alike before order was restored minutes later.

The crash prompted exchanges to implement circuit breakers that pause trading in more than 1,300 securities during periods of volatility. Uniform policies for canceling trades and eliminating stub quotes, or bids and offers at prices far away from the stock’s last sale, have also been proposed or adopted.

Declines in index futures convinced traders a “cataclysmic event” was pushing down equities on May 6, leading them to abandon the market and triggering the biggest crash in a quarter century, U.S. federal regulators said last week in their second report on the retreat.

E-Mini Futures

One trader’s routine attempt to hedge losses by selling 75,000 of CME Group Inc.’s E-mini futures contracts on the Standard & Poor’s 500 Index -- valued at about $4.1 billion -- helped set off a chain of events that sent the Dow Jones Industrial Average down as much as 998.50 points, according to the SEC and CFTC. The measure then rebounded to end the day down

347.80 points, or 3.2 percent.

The computer program the firm picked to execute the order gave no regard to prices or the speed that it was trading, the report says. Two people with knowledge of regulators’ findings identified the firm as Waddell & Reed Financial Inc., an Overland Park, Kansas-based mutual-fund company with about $68 billion in assets.

‘Absorbed Easily’

“We believe we were one of 250 firms engaging in E-mini trading during the period of the market selloff,” Waddell & Reed said in a statement in May. “We believe that trades of the size we initiated normally are absorbed easily in the market.”

Roger Hoadley, a spokesman for the company, said last week that the statement was “still accurate and relevant.”

Losses in the E-mini futures seeped into equities as arbitragers bought the contracts while selling S&P 500 stocks and an exchange-traded fund linked to the measure known as the SPDR S&P 500 ETF Trust, the report says.

The SEC and CFTC said market makers and high-frequency trading firms that facilitate the majority of U.S. stock trades, concerned the price data they were receiving was wrong or incomplete, curtailed their bidding on equities. On the public markets where internalizers sent orders, placeholder bids known as stub quotes were triggered, causing executions at “unrealistically low bids” such as 1 cent, the report says.

Retail Customers

The SEC said in a January study that almost all market orders from eight brokers with “significant retail customer accounts” are sent to wholesalers who guarantee executions for at least the national best bid or offer available on public venues. Orders that an over-the-counter market maker, or so-called internalizing broker, chooses not to trade with may be sent to exchanges.

Firms trading against the orders from individual investors usually pay discount brokers a fee, which the SEC said is typically less than a tenth of a cent per share.

The report also cleared up questions about why more than 70 percent of transactions at less than 5 cents were marked as short sales, or bets that shares will fall. Those orders were marked this way because they were sent by an over-the-counter market maker even though the customer may have owned the shares, the report said.

Almost 90 percent of the broken trades on May 6 also had price limits on them, countering speculation that market orders had produced the bulk of executions against stub quotes. The report said internalizing brokers often automatically convert market orders into buy and sell requests with limit prices intended to execute at the NBBO, or national best bid or offer.

Stub Quotes

The report also highlighted trading practices that led to executions against stub quotes. Some brokers told regulators they routed buy and sell requests to exchanges even when they knew they’d execute against stub quotes because they’re obliged to fill customer market orders at the best price. Others did so to avoid orders piling up in their systems, expecting the trades to eventually be canceled.

“Wholesalers could be forgiven in a data-driven world for doing what they did,” Selway said. They guarantee executions at the best prices, and if that is of “questionable quality,” they can route orders to exchanges, where the NBBO is created, he said. While these firms aren’t allowed to delay the execution of the orders, the securities industry could “work toward a standard a discount broker can use to let customers know their orders may not get executed with the usual amount of dispatch when there are unusual conditions,” Selway said.


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