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CFTC to Review May 6 Computer Trading in Swaps Reform

The U.S. Commodity Futures Trading Commission will examine how computerized trading that led to the May 6 stock market plunge should affect regulatory reform of the derivatives market mandated by the Dodd-Frank Act, according to an e-mailed statement from the CFTC.

On Oct. 12 the commission’s technology advisory committee, reconstituted in May after a five-year hiatus, will discuss the role high-frequency and algorithmic trading practices played in the 20-minute rout that briefly erased $862 billion in equity value. The meeting will take place in Washington.

A futures trader’s routine attempt to hedge losses on May 6 helped set off a chain of events that sent the Dow Jones Industrial Average down as much as 998.50 points, regulators said in a report on Oct. 1. Two people with knowledge of the findings by the Securities and Exchange Commission and CFTC identified the firm as Waddell & Reed Financial Inc., an Overland Park, Kansas-based mutual-fund company with about $68 billion in assets.

“As the commission focuses on new manipulation and antidisruptive trading practices in the Dodd-Frank rulemakings, the events of May 6, 2010, are equally informative as to the role of technology in the futures and swaps markets,” the CFTC statement said.

Financial Crisis

U.S. lawmakers sought to regulate swaps through the Dodd-Frank bill passed in July after the trades complicated efforts to solve the financial crisis. In most cases regulators have until July 2011 to write the new guidelines, which mandate that most interest-rate, credit-default and other swaps be processed by clearinghouses after being traded on exchanges or swap-execution facilities.

In addition to the May 6 plunge, discussions will focus on the role of technology in providing public information about trading interest in swaps and other products before and after transactions occur, the CFTC statement said. This is called pre-trade and post-trade transparency. CFTC staff will also discuss current rules being considered and how technology may affect the collection of swaps and derivatives data.

The May 6 trade of 75,000 of CME Group Inc.’s E-mini futures on the Standard & Poor’s 500 Index was executed with an algorithm that had no regard for prices or timing, according to regulators’ findings. Instead, the computer program aimed to represent 9 percent of the market’s volume. The speed of the sale drove stocks down and prompted market makers and high-frequency trading firms that facilitate the majority of transactions to curb business out of concern they were receiving incorrect or incomplete data, intensifying the crash.

Disorderly Markets

Regulators will consider whether brokers and traders should face new rules for handling orders in an electronic market, CFTC Chairman Gary Gensler said in a speech in Washington on Oct. 4. A lesson of May 6 is that a large sell order executed in an automated fashion in a volatile market can set off trading algorithms and result in disorderly markets, he added.

“Should executing brokers have to adopt certain trading practices when executing a large order by use of an algorithm, such as price or volume limits?” he said. “Should they have an obligation to monitor and make non-disruptive trading judgments?” He also asked whether those obligations should apply to customers executing their own trades.

“While I do not believe that the flash crash was the direct result of reckless misconduct in the futures market, I question what the CFTC could have done if the opposite were true,” commissioner Scott O’Malia said in the CFTC statement today. “When does high-frequency or algorithmic trading cross the line into being disruptive to our markets? Who is responsible when technology goes awry?”

The meeting will explore whether the CFTC should treat “rogue algorithms” like rogue traders, O’Malia said. Andrei Kirilenko, a senior financial economist at the CFTC, will also present a paper he co-authored about May 6 that discusses the impact of high-frequency trading on an electronic market.

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