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$4.1-billion trade set off Wall Street 'flash crash,' report finds

Federal investigators say a firm's effort to sell $4.1 billion of an indexed stock future contract triggered a 600-point drop in the Dow in 15 minutes. The firm did not intend to cause the crash, report says.

October 02, 2010|By Nathaniel Popper and Jim Puzzanghera

Reporting from New York and Washington — A highly anticipated government report about the "flash crash" of May 6 blamed the sudden stock market plunge on an unusually large order placed by a single firm that set off a cascade of selling among computer-driven, high-frequency traders.

Federal investigators found that the crash — which caused the Dow Jones industrial average to sink by nearly 1,000 points before recovering — was set off by a trading firm's effort to sell $4.1 billion in specialized futures contracts.

Prior to the release of the report Friday, the crash had been widely blamed on high-frequency traders, who use computer programs to transact massive trades. The report, issued by the Securities and Exchange Commission and the Commodity Futures Trading Commission, confirmed those traders as a factor but was surprising for the level of blame it placed on the single $4.1-billion trade. It also underscored the potential vulnerability of the markets to even a single errant or rogue trade.

"This is a case of sloppy order execution," said James Angel, a professor of finance at Georgetown University. "When you have a really large trade, you need to be very careful how you execute that order."

After the firm placed its sell order that Thursday afternoon, prices dropped sharply, sending a chilling ripple across the stock market as computerized traders panicked and stopped trading. Within 15 minutes, the Dow fell more than 600 points. It finished the day down 347 points. Although most of those losses were made up quickly, the crash has been blamed for some of the slowdown in the markets in the months since then.

Government officials have so far avoided saying whether the trade could lead to any sort of investigation or punishment of the firm.

For legal reasons, the report did not name the company that placed the trade, describing it only as "a large fundamental trader." But officials have confirmed reports that it was Waddell & Reed Financial Inc. of Overland Park, Kan.

A Waddell & Reed spokesman Friday directed questions to an earlier statement in which it said that its trades that day were seeking to hedge risk for its investors and that, "like many market participants, Waddell & Reed was affected negatively by the market activity of May 6."

Waddell & Reed is not a new-fangled trading firm — it has built its mutual fund business over the decades on a long-term, buy-and-hold strategy. On May 6, though, it appears the firm used new technologies and tools to execute its strategy.

The contract it was attempting to sell is known as the E-Mini, which was created to allow investors to buy a single futures contract for the value of the entire Standard & Poor's 500 index.

The May 6 trade of E-Minis was unusual because of its size and speed — executed in just 20 minutes — but also because it relied on a computerized algorithm with no human participation.

As E-Mini prices began to drop, the algorithm had no price limits, and so it continued trying to sell the contracts, driving prices down even further. This in turn led traders to sell off other stocks and securities.

At a certain point, the programs of some high-frequency trading firms pulled out of the market altogether, leading to further quick declines.

The investigators found that the markets were susceptible to panic that day because of widespread fears of a European economic meltdown, which had led the Dow down 2.5% for the day, even before the crash.

The report's findings undermine one of the most common arguments supporting high-frequency trading firms: their high-speed buying and selling of stocks allow other market participants to buy and sell whenever they want and at good prices. Regulators have said that during good times this is true, but that during bad times traders exiting the market can lead to precipitous declines.

Rep. Paul E. Kanjorski (D-Pa.), who chairs a House subcommittee overseeing capital markets, said Friday that Congress might need to act to prevent a repeat.

"The SEC and CFTC report confirms that faster markets do not always lead to better markets," he said. "While automated, high-frequency trading may provide our markets with some benefits, it can also carry the potential for serious harm and market mischief."

nathaniel.popper@latimes.com

jim.puzzanghera@latimes.com

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