Fragmentation of U.S. Equity Markets Worsened Plunge (Update2)

Fragmentation of U.S. Equity Markets Worsened Plunge (Update2)

A “mismatch of liquidity,” selling in futures and exchange-traded funds that fed into stocks and the use of market orders turned an orderly stock-market plunge into a rout on May 6, a report by federal regulators said.

The Securities and Exchange Commission and the Commodity Futures Trading Commission said in a joint report today that they found no evidence that mistaken orders, terrorism or computer sabotage led the drop, which briefly sent the Dow Jones Industrial Average down 998.5 points. The SEC earlier proposed rules to halt trading in individual stocks that swing more than 10 percent within 5 minutes to keep the selloff from recurring.

While the study stops short of assigning blame, its findings support a conclusion that conflicting rules on as many as 50 U.S. market centers fueled a chain reaction of selling that helped erase $1 trillion in stock value. Regulators are still investigating the plunge, which spurred congressional hearings and the issuance of subpoenas last week.

“In the U.S. securities market structure, many different trading venues, including multiple exchanges, alternative trading systems and broker-dealers all trade the same stocks simultaneously,” the report said. “Disparate practices potentially could have hampered linkages among some of these trading venues and led to fragmented trading.”

1987 Crash

The Dow average fell as much as 9.2 percent on May 6, its biggest tumble since the crash of 1987, before closing down 3.2 percent. The Standard & Poor’s 500 Index fell 79 points in the 46 minutes after 2 p.m. and companies such as Accenture Plc and Exelon Corp. fell to pennies before rebounding minutes later. Those trades were later canceled.

Regulators are focusing on six aspects of the selloff, including whether declines in stocks, ETFs and futures on the Standard & Poor’s 500 Index spread among each other. A “generalized severe mismatch in liquidity,” possibly worsened by the withdrawal of orders by electronic market makers, and stub quotes, or offers to buy securities for pennies that are never supposed to be used, may have exacerbated the decline.

Absent from the report is a finding that the NYSE’s program for slowing the market, so-called liquidity replenishment points in which trading is switched to manual auctions, widened stock swings. Rapid-fire price changes trigger the LRP auctions, potentially encouraging electronic orders to flow to other exchanges with few if any offers to buy shares, said Larry Leibowitz, NYSE’s chief operating officer, on May 6.

LRP Role

“Some have suggested that LRPs exacerbated price volatility on May 6 by causing a net loss of liquidity as orders were routed to other trading venues,” the report said. “If accurate, this potentially could cause some NYSE securities to decline further than the broad market decline. Others believe that the LRP mechanism served to attract additional liquidity that helped soak up some of the excess selling interest. We are analyzing the effect of the LRPs closely.”

The report cites evidence that buying interest began to dry up as the selloff worsened in the 2:30 p.m. to 3 p.m. interval. Widening bid-ask spreads for E-mini futures, swings in volume from second to second and the behavior of traders who facilitate trading in futures markets, known as liquidity providers, suggest that demand decreased during the period, it found.

Liquidity Withdrawal

“Starting at approximately 2:35 p.m. liquidity providers began limiting their trading activity” in the Chicago Mercantile Exchange market for E-mini contracts, it said. “By 2:45:28 p.m., liquidity providers accounted for 46 percent of all transaction sides, lower than their participation percentage between 2:30 p.m. and 2:34 p.m. By 3 p.m., the liquidity providers accounted for 41 percent of transaction sides.”

Echoing the congressional testimony of CFTC Chairman Gary Gensler on May 11, the report cited sales of S&P 500 E-mini contracts by a single trader starting at about 2:32 p.m. on the day of the plunge. The trader “sold on the way down” and made up 9 percent of the volume during the period, the report said.

“Data from the CME order book indicates that, although trading volume in the E-mini S&P 500 futures was very high on May 6, there were many more sell orders than there were buy orders from 2:30 p.m. to 2:45 p.m.,” the report said. “Considerable selling pressure at this vulnerable period in time may have contributed to declining prices in the E-mini S&P 500 and other equivalent products such as the SPY,” or the SPDR S&P 500 Trust ETF, it said.

Uniform Halts

Schapiro and executives from the biggest exchanges, including NYSE Euronext and Nasdaq OMX Group Inc., agreed that all venues need uniform halts to shut down trading during investor panics. Circuit breakers proposed with the Financial Industry Regulatory Authority would be triggered in all markets by gains or declines of 10 percent over 5 minutes in S&P 500 companies, according to an e-mailed statement today.

Instructions to sell stock at the available price known as market orders, as well as stop-loss commands that “turn into market orders” when prices are falling, may have “particularly affected” declines in the broader market.

The SEC and CFTC face pressure to show they have a grip on increasingly fragmented markets dominated by computerized trading of stocks and futures. Representative Paul Kanjorski, who leads the House panel, called hearings last week to scrutinize whether technology and competition for New York-based NYSE and Nasdaq contributed to the free fall in stock prices.

“As old trading methods have given way to modern techniques, the rules governing our market architecture have lagged behind,” said Kanjorski, a Pennsylvania Democrat. “The markets were hardly fair or orderly.”

Algorithm Trades

The role of proprietary speculators who base trades on mathematical algorithms was left unanswered in the report. Delaware Senator Ted Kaufman asked the SEC and CFTC to tell Congress whether “major banks employ algorithmic trading practices that represent potential systemic risks to the markets” in statements the day after the plunge.

“We are also considering whether initiatives are warranted to address destabilizing short-term strategies, to the extent that they contributed to the May 6 market disruption,” the report said. “If they contributed significantly to the precipitous decline, however, we must consider whether additional regulatory requirements are necessary.”