05.15.10
The May 6, 2010 Market Plunge – A Possible Cascade Event
Within the span of an hour on May 6, the Dow Jones Industrial Average dropped almost 900 points, just short of a 10% loss. The initial speculation that a “fat finger” trading error may have occurred in Procter & Gamble or other company has now been discounted. Terrorist attacks and technical glitches have also been ruled out.
The sudden drop instead may be the result of an increasingly complex and interdependent equity market system that has become highly electronic in nature, simultaneously trading shares of stocks on numerous exchanges across the globe. An unintended consequence of the growing technological sophistication of the markets may be the increasing likelihood of breaks occurring in an otherwise orderly pricing system during times of economic stress. The rapid loss of a functioning system of quotes has been recently observed in individual equities when computerized sellers cannot find enough buyers, but never before has been seen across the entire US equity marketplace.
DJIA Intraday Pricing 5-6-10
While many facts are still coming to light, the events of May 6 may have unfolded something like this:
- After a day and a half of growing concern over government debt issues in Europe, equity markets were unsettled and generally dropping in pricing levels. There was also a belief that a technical correction or pause in equity pricing could be looming in the coming days and weeks.
- The earliest sign of big trouble on May 6 was observed at the Chicago Mercantile Exchange, where a sudden drop occurred in the value of e-minis, which are futures contracts of the S&P 500 index.
- It is so far unknown what set off the drop in S&P futures, but the sharp plunge may have then pushed down the underlying valuations of most individual stocks in the S&P Index. The vast majority of equities in the S&P are traded on the NYSE.
- As prices dropped, stop loss orders that are part of many typical offers were automatically converted into market sell orders, causing further selling pressure on specific equities. Ironically, even though stop loss orders are designed to prevent larger losses from occurring in the event of a market downturn, they had the effect of locking in losses after the markets subsequently recovered.
- As a possible response to the raft of sell orders being executed, some high frequency traders sold their current positions, and then simply withdrew from the market until a bottom was achieved. This had the dual effect of adding to the downward pricing pressure as well as drying up liquidity at the very time when transactions were most needed.
- Some participants may have also been rattled by an earlier glitch in wireless devices used by floor traders which had occurred a few days before. In a review of the transactions of May 6, no such electronic flaw was found. Some traders may have believed however that the problem with non-functioning hand-held devices was re-emerging.
- The reduction of specialists over the last several years at the NYSE may have also added to the economic stress of the day. With New York becoming more electronic in its trading, far fewer specialists exist with the specific job duty of providing a market when traders cannot be found on both sides of a transaction.
- As the sell orders poured in, the NYSE went into slow mode for many individual stocks, with floor traders manually seeking out bidders. This was supposed to allow market participants time to think through transactions, potentially becoming buyers when they saw opportunities arising.
- Circuit breakers on specific stocks existed only on the NYSE, however. Once the slow trading restriction was imposed in New York, trading simply moved to other electronic exchanges. This has been a growing tendancy lately, with a decentralized and computerized system of 50 or more exchanges and trading networks now existing. With many potential buyers slowed down in their activities in New York, the market-wide pricing equilibrium tilted dramatically towards the sell side. In another fitting irony, imposition of circuit breakers that were designed for market relief actually contributed to the problem by effectively removing buyers and liquidity from the system.
- Many stocks have a stub quote of one penny. This quote is not meant to be used for actual transactions, but only as an electronic place holder for quotes on individual equities. As liquidity and buyers disappeared from the exchanges however, electronic searches were still looking for the best available price. When only the stub quotes could be located, numerous trades were automatically executed at or near zero value per share.
- As the prices careened downward, huge disparities opened up between the quoted price and perceived fundamental value. Large, institutional buyers and traders began emerging to take advantage of this divergence in value. As more buyers entered the markets, pricing on many equities rose. After an hour or more of pricing free fall, the markets re-established a still shaky, but functioning equilibrium.
- Buy and hold types of investors were generally unaffected by the day’s events, as the ending quotes on several indexes were down only 3% from the start of the episode.
- Many of the trades were ultimately cancelled by exchanges that exercised their discretion to correct ”erroneous” orders. Any trade that was off 60% or more in value from the start of the difficulties was subject to cancellation. The voided orders produced many complaints from indiviudals who thought they had made a once-in-a-lifetime trade. Complaints also emanated from brokerage clients who were unable to access overwhelmed financial web-sites and phone systems.
Possible remedies include:
- Market-wide circuit breakers for both individual equities and overall indexes could be imposed. If all exchanges simultaneously slowed down in times of severe uncertainty, buyers and sellers at all exchanges would be able to equally sort through their positions in a methodical manner.
- Elimination of stub quotes would prevent computers from executing unrealistic quotes that are not based on underlying valuations.
- A requirement of a minimum sale price maybe useful, rather than reliance on market orders. This is a common practice in Europe, with many larger orders requiring a minimum price for a sale. No execution of the order is thus possible below the limit. This would prevent a ridiculous price from being executed on a market order that presupposes a highly liquid and well-functioning marketplace of willing buyers and sellers.
- A system-wide rejection of orders could occur if the offer is more than 5% away from the last executed price. This is currently a standard practice on the BATS Exchange in the US. In fact, at the height of the disturbance on May 6, BATS declined almost 95% of the quotes going through its system, preventing 47.6 million orders from executing. It is believed that many of those orders were then attempted and executed on other exchanges.
Overall, the market activities of May 6 may be best described as a cascade event. Known in the fields of chemistry, ecology, medicine, and electronics, an unforeseen chain of events will cascade across and affect the stability of a system, often in uncontrolled and unpredictable ways. As applied to the capital markets, any single action on the day in question may have produced only a barely perceptable impact on pricing. In combination however, the independent activities of a multitude of market participants generated a chain reaction which destabilized the capital markets for all equities. It was an amazing display of a highly improbable outcome actually coming to fruition through a lightning-fast, global interaction of decentralized economic structures.
Numerous sources were reviewed and used for this post, including WSJ; NY Times; AP; Reuters; Columbia University Business School posts; and Congressional testimony from the SEC. The above graph is taken from Google Finance, and was originally seen in a Columbia University blog.Main web-site is at: www.kaufholdco.com
