Life After the “Flash Crash”: Book Excerpt from The Speed Traders, by Edgar Perez

The Speed Traders: An Insider’s Look at the New High-Frequency PhenomenonAfter May 6, 2010, an abundance of unanswered questions remained as the entire financial world sought to find a reasonable explanation for the events that befell the market. Who or what was the culprit? Why did markets spin out of control so rapidly? What needed to be done to prevent this from happening again? The Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) said they were examining the cause of the unusual trading activity. Mary L. Schapiro, chairwoman of the SEC, and Gary Gensler, head of the CFTC, held conference calls with overseers of the exchanges who were reviewing trading tapes from the day.

One official said that he identified “a huge, anomalous, unexplained surge in selling” at about 2:45 p.m. The source remained unknown, but that jolt apparently set off trading based on computer algorithms, which, in turn, rippled across indexes and spiraled out of control. It would be only a week later that Reuters identified the mutual fund complex that triggered the selloff.

Initial Speculation, May 2010

Was it a software glitch? A hacker’s attack? A foreign power? A Citi trader entering an erroneous order? These suspicions and rumors, along with many others, spread out quickly on May 6. Only days later, the market was slowly able to catch a glimpse of what and who were behind the “flash crash.”

May 12, 2010

“High-frequency trading doesn’t benefit the financial system and should be taxed to raise money for the Securities and Exchange Commission,” said Mario Gabelli, chairman and CEO of Gamco Investors, Inc., on this date. “Is the net benefit of having this extra liquidity worth it to the system? The answer is no,” Gabelli said in an interview on Bloomberg Television. “Should we put a tax on this fast trading to raise revenues for the SEC? The answer is yes, so that investors benefit, not traders.”

He complained that the flash traders, the dark pools, and other traders were taking over the investment process and, at the margin, becoming too important. He said that the best way investors can protect themselves from market turmoil was to examine the intrinsic value of an enterprise, which doesn’t change minute by minute the way commodities change, and look through the daily volatility.

May 14, 2010

The big mystery seller of futures contracts during the market meltdown on May 6 had not been a hedge fund or a high-frequency trader, as many had suspected, but money manager Waddell & Reed Financial, Inc., according to a document obtained by Reuters.

The firm on May 6 sold a large order of E-Mini contracts during a 20-minute span in which U.S. equities markets plunged, briefly wiping out nearly $1 trillion in market capital, an internal document from Chicago Mercantile Exchange parent CME Group, Inc., said on this date. The E-Minis are one of the most liquid futures contracts in the world, providing holders exposure to the benchmark Standard & Poor’s 500 Index. The contracts can act as a directional indicator for the underlying stock index. Regulators and exchange officials quickly focused on Waddell’s sale of 75,000 E-Mini contracts, which the document said “superficially appeared to be anomalous activity.”

Waddell managed the $22.1 billion Ivy Asset Strategy fund, which was well known for hedging with equity index futures when manager Mike Avery, who was also chief investment officer at the company, felt uneasy about the market. Back then, it was still unclear what impact the trading in the E-Minis had on stock prices during the plunge, but regulators had scrutinized futures trading because the sharp decline in that market preceded the dive in the broader U.S. equities market. The document said that during the sell-off and subsequent rally, other active traders in E-Minis included Jump Trading, Goldman Sachs Group, Inc., Interactive Brokers Group, Inc., JPMorgan Chase & Co., and Citadel Group.

Kansas-based Waddell had declined to return calls seeking comment. In a statement, however, the company said, “Like many market participants, Waddell & Reed was affected negatively by the market activity of May 6.” Waddell said in its statement that it often uses futures trading to “protect fund investors from downside risk,” and on May 6, it executed several trading strategies, including the use of index futures contracts as part of normal operations. Of course, the new normal also included Waddell insiders selling their shares, in anticipation of the scrutiny they were sure to face in the coming months.

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