High frequency traders have been widely blamed for
exacerbating the crash, but the report did not satisfy those
thirsting for the HFT firms’ blood.
The SEC’s official
explanation for the events of May 6 – when 1,000
points were wiped off the Dow Jones Index in 20 minutes
– rested on the snowball effects of a single large
E-Mini S&P 500 Futures trade by one firm.
The joint CFTC-SEC Advisory
Committee on Emerging Regulatory Issues – a group of
eight academics and regulators – was convened in the
aftermath of the crash.
It has made 14 suggestions,
including an extension of temporary solutions designed to alter
the way trades are executed and the venues on which they are
How long is temporary?
The temporary measures brought in after
the Flash Crash include circuit breakers, which trigger a pause
in the trading of a security and options linked to it, if price
moves become too extreme.
The committee proposed keeping the
pauses but changing them to a limit up/limit down system. Their
scope would be expanded to include "all but the most inactively
traded equity securities, ETFs, options and single stock
The SEC is already considering a
limit up/limit down rule for US equity markets. It would put
the market into a "limit state" if a stock moved by a set
percentage over a rolling five minute period. During the limit
state, executions could not take place outside a specified
price band. Unlike a pause, this would allow the market to exit
the limit state naturally when contra-side liquidity appeared
at a price above the limit price.
The committee has yet to decide
whether to allow equity options and futures to continue trading
during a limit period. Members argued the crash had
demonstrated the interconnectedness of the equity and
derivatives markets. They said CME’s Stop Logic
Functionality, which allows a five second pause in trading, had
worked well on May 6, but that in future such a period could be
insufficient if a big news event occurred which could trigger a
substantial market movement.
The committee stopped short of
calling for an overhaul of the five second pause used by US
derivatives exchanges, but said they should examine their
pre-trade risk safeguards.
Tinkering with HFT
In the aftermath of the crash, US
politicians were quick to declare algorithmic traders at fault,
and urged regulators to clamp down on the practice. The
committee trod a different path, urging HFT firms to show
In particular, the report
highlighted the CFTC’s recent proposal of new
rules to specify certain trading and quoting practices as
disruptive of fair and equitable trading – notably
executing large orders in a disorderly way. The CFTC is also
considering outlining specific duties of supervision relating
to monitoring automated trading systems to prevent disruptive
The Committee said it "strongly"
believed the CFTC should impose supervisory provisions, similar
to those set by the SEC, on any FCM sponsoring algorithmic
orders to an exchange. Algo trading firms would have to
demonstrate they had carefully evaluated how an algorithm would
operate in a number of scenarios engendering high market
Such measures are particularly
significant, since one of the triggers for the Flash Crash was
the timing of a mutual fund’s algorithmically
executed E-Mini S&P 500 Futures sale, which occurred on a
bearish day in the markets and at a time of reduced
Regulators have not named the firm,
though it has been widely reported to be Waddell & Reed
Financial. Over about 20 minutes, the firm used an algorithm to
sell 75,000 of the futures at CME, worth about $4.1bn,
apparently to hedge a long equity position.
Paying for liquidity
Official reports into the
day’s events found the crash to be something of a
perfect storm, exacerbated by algorithmic trading. A lack of
liquidity was cited as the key driver in the
The committee’s report
echoed those findings, but suggested stock exchanges could do
more to encourage liquidity in shares.
One method mooted was introducing
keener incentives in maker/taker pricing schemes, especially at
peak times. Such schemes rebate firms for providing quotes,
while those who place orders are charged "taker" access
The committee also said the SEC
should look into incentives or rules that would increase a
market maker’s responsibilites, for example by
making it "regularly" provide quotes that are "reasonably
related to the market".
While the committee was softer on
HFT firms than some expected, it did propose that regulators
seek ways to make them contribute to the cost of surveillance.
The CFTC noted schemes in the equity
markets which charge HFT players that have high ratios of
cancelled trades to actual trades, but it did accept there were
several obstacles to introducing similar schemes for
"At a minimum, we believe that the
participants of those strategies should properly absorb the
externalised costs of their activity. While trading is
concentrated in the stock index and single stock futures
markets, we also believe that the CFTC should evaluate whether
a similar fee initiative would be appropriate," the committee