1 large trader led to May 6 stock market plunge

[October 02, 2010]  WASHINGTON (AP) -- A trading firm's use of a computer sell order triggered the May 6 market plunge, which sent the Dow Jones industrial average careening nearly 1,000 points in less than a half-hour, federal regulators said Friday.

A report by the Securities and Exchange Commission and the Commodity Futures Trading Commission determined that the so-called "flash crash" occurred when the trading firm executed a computerized selling program in an already stressed market.

The firm's trade, worth $4.1 billion, led to a chain of events that ended with market players swiftly pulling their money from the stock market, the report said.

The report does not name the trading firm. But only one trade that day fit the description in the report. The firm Waddell & Reed, based in Overland Park, Kan., has acknowledged making such a trade that day.

The free-fall highlighted the complexity and perils of the fast-evolving securities markets. Electronic trading platforms now compete with the traditional exchanges. Stocks are traded on about 50 exchanges beyond the New York Stock Exchange and the Nasdaq Stock Market. Computers using mathematical formulas give so-called "high frequency" traders a split-second edge. Electronic errors at high speeds can ripple through markets.

The stock market was already stressed even before the plunge that day. Anxiety was mounting over the debt crisis in Europe. The Dow Jones had been down about 2.5 percent at 2:30 p.m., when the trader placed an enormous sell order on a futures index of the S&P's index, called the E-Mini S&P 500. The trade was automated by a computer algorithm that was trying to hedge its risk from price declines.

In that one trade, 75,000 contracts were sold within 20 minutes. It was the largest trade of that investment since the start of the year. The firm's previous transaction of that size took more than five hours, the report notes. The trade triggered aggressive selling of the futures contracts and that sent the index sinking about 3 percent in four minutes.

The report said the design of the firm's trading formula may have amplified the rush to sell.

It said the formula ignored price changes and responded to the volume of trading. The automated program sped up the firm's selling as other market players began trading the first block of futures contracts that flooded the market.

In a previous statement, Waddell & Reed acknowledged that it had sold the contracts to reduce its funds' risk quickly. It said traders feared that the European debt crisis could spread to U.S. markets.

The company maintained that the transaction "was not the cause of any abnormal price action." It said the move involved just 1 percent of the contracts of that type that changed hands on May 6. The sale would not have caused problems in a normal market, the company said.

"Our portfolio managers and the funds acted in a manner consistent with the interests of their fund shareholders," it said.

The exchange where the E-Mini trades occurred agreed that the trade by Waddell & Reed probably didn't spark the plunge. The exchange operated normally and the trade was proper, Chicago Mercantile Exchange Inc. said in a statement. It said the plunge probably resulted from widespread concern about news events. It said E-Mini prices often change just before price swings in the broader financial markets.

Nearly 21,000 trades were canceled in the ensuing weeks because the exchanges deemed them erroneous.

Responding to the episode, the SEC and the major U.S. exchanges agreed on a six-month pilot program that briefly halts trading of some stocks that mark big price swings. The new "circuit breakers" are in effect until Dec. 10. Under the rules, trading of any Standard & Poor's 500 or Russell 1000 stock that rises or falls 10 percent or more within a five-minute span is halted for five additional minutes.

On May 6, about 30 stocks listed in the S&P 500 index fell at least 10 percent within five minutes.

SEC Chairman Mary Schapiro has said anxiety over the "flash crash" may have contributed to the withdrawal of retail investors from the stock market in recent months.

Schapiro said recently the SEC will consider imposing so-called "limit up-limit down" requirements that would bar any trades outside specified boundaries. Limit up-limit down restrictions, which apply to the commodity futures markets, impose a maximum price change higher or lower in a given day.

Owners of financial exchanges issued statements endorsing the possible rule changes. Trading limits such as limit up-limit down rules are "a vital means to prevent clearly erroneous trades," and are more effective than circuit breakers, said Randy Williams, a spokesman for BATS Global Markets. BATS operates the third-largest stock trading platform.

Rep. Paul Kanjorski, D-Pa., who heads the House Financial Services subcommittee that oversees the SEC, said the new report "confirms that faster markets do not always lead to better markets."

"While automated, high-frequency trading may provide our markets with some benefits, it can also carry the potential for serious harm and market mischief," Kanjorski said.

[Associated Press; By MARCY GORDON and DANIEL WAGNER]

AP Business Writer David K. Randall in New York contributed to this report.

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