The SEC Swings And Misses On Flash Crash Report

Data is good if it has a context.  The SEC did an investigation of the flash crash and once their statement was out I wondered what they really looked at.  When the sausage gets made in Washington DC it’s not pretty.  No doubt, lawyers from interested parties scanned the SEC statement before it was released.

Traders that I have spoken with in stock markets, option markets, and futures markets all disagree with the SEC statement. Are we smarter than the SEC?  Many times, yes we are. Traders don’t generally give a nuanced opinion.  When asked, they tell it like it really is.  Given new information, their opinions might change.  That’s why they survive in a competitive marketplace.

The flash crash confounds many market participants because electronic trading was supposed to be so efficient.  It was a panacea for structural problems in the market.  Supposedly more people were going to get into the market, so markets would be bigger, deeper and more transparent. The machine was supposed to be better than a simple man.

The flash crash exposed several vulnerabilities to the existing structural system we have. Rent seeking entities want to preserve those inefficient non-competitive structures, so they are doing everything they can to push the analysis of the flash crash under the rug. They want to move on.

But we shouldn’t move on. We need to expose all the ugly warts of the system. All the games that are being played. We need to end it, now.  Since the flash crash happened, several mini flash crashes have occurred in single stocks.  They have happened despite the electronic circuit breakers that were installed to prevent them.  Even liquid stocks like Apple (AAPL) have had crashes.  This is damaging to our financial system in insidious ways that are not readily apparent.

CFO’s access market to raise capital for their companies.  People put savings in the market to build nest eggs.  Pension funds put money in the market to build wealth for retirees.  Flash crashes and the games that are being played on the SEC side of the market place have undermined the confidence of all investors.

The regulated futures side of the marketplace works differently.  The market isn’t fragmented.  It’s really easy to piece together data.  A day after the crash, CME knew who traded with whom, how many, and how much.  In testimony before the Senate Banking Committee, Chairman Terry Duffy was the only exchange official to present real data on what happened.  The other exchange officials were still grasping at straws, trying to piece together the puzzle.  The regulators had nary a clue as to what went on.

In order to really understand, it helps to understand the way the market is structured. The emini S+P futures trade side by side with the pit, but the emini is 100% electronic. When the pit is open (8:30am-3:15pm), the emini futures trade electronically side by side with an electronic “big” S+P contract. The electronic contract trades in .25 of a point. The big open outcry contract trades in .10 of a point. Obviously, there is an arbitrage between the two contracts.  Most market participants use the emini electronic version to trade.

The money numbers that get tossed around are used to deceive people too.  CME numbers are in “notional value”.  Trading a million dollars worth of a big S+P contract is a 4 lot trade. In the electronic version, the emini, it’s a 20 lot.  This is considered pretty small.  All futures trading is done on margins set by the exchange, so a percentage of cash is put up to hold a position.  In the cash market, if you do a million dollar trade, someone actually puts a million bucks on the line.  Simply citing money and dollar figures gets confusing.

There are no other S+P 500 futures contracts in the world. All the action is in one place. There are other look alike contracts, like the SPY in the stock market, or the S+P options at the CBOE. But unlike the SEC world, there is no payment for order flow, dark pools, specialists, internalization or fragmentation of liquidity. If you want to compete, you enter in the same door as everyone else. Kind of like Thunderdome.

An audio transcription of the flash crash:

When armageddon hit, the futures dropped thousands of points in seconds. The above clip is a narrative done by a person that stands next to the S+P futures pit. He is describing the action in the human pit. No human could speak fast enough to keep up with every single price change in the market when the flash crash happened.  There is also no guarantee that he is right on every single word he says.  He is very good at what he does, but he is human.

When inspecting data on the electronic emini contract, it gets really interesting.  The emini traded at every price all the way down, and all the way up.  It kept a .25 wide spread with bids and offers on each side. That is amazing.  No other contract in the world can say that. The market didn’t shut down, like the stock market.  It traded. That’s what markets are supposed to do, especially in times of stress.

Nanex has come out with more data post SEC statement.  This analysis and data totally contradict the SEC, confirming many trader suspicions. Charts if you click the link.

“We have obtained the Waddell & Reed (W&R) May 6, 2010 trade executions from the executing broker in the June 2010 eMini futures contract. There were 6,438 trades totalling 75,000 contracts. We matched them by time, price and size to the 147,577 trades (844,513 contracts) in the CME time and sales data between 14:32 and 14:52 (they matched exactly). One-second resolution charts of the W&R trades along with other eMini trades are shown below in various time frames.

The SEC report identified a Sell Algorithm selling 75,000 contracts as the cause of the flash crash. If the “Sell Algorithm” in the SEC report refers to the Waddell & Reed trades, then there is a problem. A big one. Looking at the trades in context with the other trades during that time, they do not appear to be significant. The W&R trades also do not occur near the ignition point (14:42:44.075) we identified earlier. Furthermore, the W&R trades are practically absent during the torrential sell-off that began at 14:44:20. The bulk of the W&R trades occurred after the market bottomed and was rocketing higher — a point in time that the SEC report tells us the market was out of liquidity. Finally, the data makes it clear that the algorithm does take price into consideration; you can see it stops selling if the price moves down over a short period of time.”

Vlad Khandros said, “However, “it can be dangerous to base decisions off of a small set of data points,” Khandros noted. “Until more data is more accessible, we will continue to have a host of theories and concerns that may or may not be in touch with reality.”  The SEC side of the market wants to avoid all reality.

Amazingly, the Waddell order was filled on the way up, not the way down!  This means something else was the trigger for the crash.  Waddell’s algorithm reacted to the crash by selling futures.  That’s what it was supposed to do.

It would be interesting on the SEC side to see where order flow actually went.  Groups like Citadel, that purchase order flow from discounters like ETrade, refused orders.  No different than market makers that turned their machines off.  Why would someone refuse orders?  Simple, they couldn’t make money on them. That’s the only reason they are buying the order flow in the first place, to trade against it and arbitrage it back into the marketplace.  This is a legal practice endorsed by the rules of the SEC.  It’s unseemly, and anti-competitive, but it exists.

Might be really interesting to know all the data from all the dark pools.  How were their trades matched up?  Who traded with whom, and why were trades sent their?  How wide were the bid/ask spreads, and did they keep those tight spreads all the way up and down?

High Frequency Trading might be a villain.  But until you know if they were using programs like “quote stuffing”, which are designed to shut down a market to give them an advantage no one knows. I doubt seriously if HFT guys were the Snidely Whiplashes of the flash crash.  More likely they got burned because the market moved so fast.  My gut tells me they were the buyers on the down move, and the sellers on the up.   Most of their programs like a little stability so they can try and manipulate the stops and big orders lying around.

What about reinstituting an uptick rule?  That would take selling pressure off markets that declined like the flash crash? The SEC did away with the uptick rule in 2007 to the detriment of the marketplace.

With all the chicanery illustrated in Charlie Gasparino’s new book, the fact that government accepts no responsibility for any part of the financial crisis, it doesn’t surprise me that the SEC took the easy way out and pointed a finger.

I keep coming back to the structure of the marketplace on the SEC side.  The big boys are gaming the system.  If the cash equity side of the marketplace wasn’t so fragmented and liquidity had to compete on a level playing field, the flash crash probably wouldn’t have happened.

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