SEC Report: Uncovering The Role Of ETFs In The “Flash Crash”

by on May 20, 2010

May 6, 2010 has become a day that will live in infamy on Wall Street, joining the “Black Monday” of 1987 and other days marked by steep declines in equity markets. A wave of risk aversion was washing over financial markets on May 6, with many major indexes off by several percentage points in afternoon trading. But when benchmarks suddenly plunged around 2:45, many investors immediately began to suspect abnormalities. As reports of large cap companies temporarily becoming penny stocks began to emerge, theories of what went wrong began to circulate (see Ten Shocking ETF Charts From The “Flash Crash”).

In the days following the “flash crash,” it became apparent that ETFs had accounted for a disproportionately large percentage of the trades that were ultimately canceled, prompting calls for improvements to trading systems and updates to procedures for handling ETF trades. With exchanges and regulators tight-lipped on the details surrounding the bizarre events, speculation has continued to build over the last week.

Earlier this week, the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) released a report of preliminary findings regarding the market events of May 6. While the report (see PDF here) didn’t answer all the questions on the minds of investors, it does provide some interesting insights. Among the findings:

  • “Possible linkage” between the decline in the prices of index ETFs and subsequent waves of selling in individual securities
  • Markets experienced a “severe mismatch in liquidity,” perhaps exacerbated by the withdrawal of market makers and automated stop-loss market orders
  • The aforementioned liquidity mismatch may have been attributable to “disparate trading conventions” across exchanges; some exchanges may have slowed trading as others maintained normal operations

The report also noted that no evidence of a “fat finger” error, one popular explanation. The organizations also reported no evidence of computer hacking or terrorist activities, although those scenarios hadn’t been completely ruled out.

ETF Impact

With ETFs accounting for approximately 70% of canceled trades on May 6, the SEC/CFTC report notes several areas of ongoing investigation. Specifically, the role of authorized participants will be the subject of ongoing investigations; it’s possible that an “inability to hedge their ETF positions during periods of severe volatility” was a contributing factor to the lapse in liquidity. The impact of ETF stop loss orders from retail investors is also under investigation, as regulators attempt to uncover the complete reasons behind the ETF fiasco.

Stay tuned for more on this story–more details are likely forthcoming, and some major changes impacting ETFs could be int he works.

Disclosure: No positions at time of writing.