How One Very Naughty Algorithm Ruined Everyone's Day....

The chaos theory says that small differences in initial conditions can yield widely diverging outcomes. Thus it was that on May 6th when a mutual fund in Kansas entered a rather large ($4.1bn) sell order in E-mini S&P 500 futures contracts on the CME, the reverberations were felt throughout the marketplace. The order sparked a totally human panic on a day when fear was in the air and sentiment was leaning toward the bearish. The fire was then fueled and fanned by algorithmic trading strategies and high frequency trading, causing an unprecedented drop within minutes.

As regulators said following the flash crash: "a complex web of traders and trading strategies" links the fragmented multitude of markets here in the U.S. And, like dominoes, when one goes the rest follow. That a large sell order for E-mini S&P 500 contracts on the CME, executed by an aggressive broker's algorithm, had such a devastating knock-on effect throughout the whole of the marketplace is telling. At first, high frequency trading programs absorbed the liquidity but, as prices dove, they changed their tack and began to sell as well. Liquidity was choked off. As traders tried to make sense of the situation, it because clear that the rest of the market was a-tumbling.

The futures contract - technically an ETF - is a stock market index futures contract based on the S&P 500. And the S&P 500 after all is made up of 500 individual equities shares. Panic, although a human emotion, can also spread in the electronic sense. In this case when the ETF algos ‘panicked’, the 'emotion' spread across other asset classes in an instant. Inconsistent and inhomogeneous trading rules across the various destinations worsened the effect. As trading halted on NYSE other destinations kept churning, but liquidity was already strangled.

The post-crash joint report by the SEC and CFTC notes that on the morning of the flash crash there was a decidedly unsettled feeling in the market. The European debt crisis was top of the list, and risk indicators included higher premiums on credit default swaps for debt from Greece, Portugal, Spain, Italy, and Ireland and a weak Euro. The VIX shot up by over 30%, the fourth largest single-day increase. Prices on gold futures rose 2.5%, while yields of ten-year Treasuries fell nearly 5% as investors engaged in a “flight to quality", said the report.

Clearly it wasn't a good day to sell; but we all make mistakes. The report highlights just how easy it is to make a well-intentioned trading faux pas that can wipe hundreds of billions of dollars off the market within minutes.

Lessons have been learned and they will help to prevent another flash crash. I have some to add:

• Perform comprehensive pre-trade analysis, including by backtesting algorithms under a wide range of circumstances using realistic market simulation – If the mutual fund in question or its executing broker - had done a thorough back-test of its trading strategy, using some of the dire indicators and conditions present, it might have thought twice about selling so aggressively - possibly preventing the crash.
• "Light up" the algorithmic trading process. Visibility during the trading process is crucial. Market monitoring and surveillance technology exists than can monitor the markets for anomalous behavior and alert the parties involved if it is spotted. Red alerts should have been going off in the broker, with real-time risk analytics highlighting impending problems. Also, the regulators should have been able to see an “early warning” and respond from a NORAD-style monitoring HQ.
• Homogenize trading rules across all exchanges and ECNs. When one halts trading they all halt - for the same reason and for the same amount of time.

Gary Gensler, chairman of the CFTC, said following the report that perhaps both brokers and customers need to be obligated  "to monitor and make non-disruptive trading judgments." As Mr. Gensler noted, high volume is not necessarily an indicator of real liquidity. The more visibility we have into trading, the more responsive we can be and the more likely we are to avoid another flash crash.