Wednesday, May 19, 2010

SEC, CFTC Have Few Answers in Preliminary Report on Market Upheaval

The SEC and CFTC staffs may have concluded what did NOT cause the dramatic market turmoil on May 6, but their preliminary report offers few answers as to what did cause the upheaval. According to the report, the staff review is in its preliminary stages and is ongoing.

Initially, the staffers indicated that they had found no evidence that these events were triggered by “fat finger” errors, computer hacking, or terrorist activity, although they could not completely rule out these possibilities. While not identifying any particular cause, the report focuses on six major themes:

1) a possible linkage between the price decline in index products coupled with simultaneous and subsequent waves of selling in individual securities;
2) a severe mismatch in liquidity that may have been exacerbated by the withdrawal of liquidity by electronic market makers and the use of market orders, including automated stop-loss market orders designed to protect gains in recent market advances;
3) the impact on the liquidity mismatch of disparate trading conventions among various exchanges, with trading slowed in one venue while continuing normally in another;
4) the impact of the use of “stub quotes”, which technically provide a “two sided quote” but are at such low or high prices that they are not intended to be executed;
5) the use of market orders, stop loss market orders and stop loss limit orders that, when coupled with sharp declines in prices, for both equity and futures markets, may have contributed to market instability and a temporary breakdown in orderly trading; and
6) the impact on ETFs, which suffered a disproportionate number of broken trades relative to other securities.


The SEC staff stated that they will continue the ongoing investigation into the nature of the overall market liquidity dislocation and the impact on individual stocks. The staff anticipates that SROs will propose circuit breakers for individual stocks that are designed to address temporary liquidity dislocation. The procedures for breaking trades that occur at off-market prices should also be improved to provide investors greater consistency, transparency and predictability. The report stated that the staff will review a range of other policy options, including addressing the use of stub quotes, reviewing the obligations of professional liquidity providers and evaluating the use of various order types.


The CFTC staff will continue its review of the activity of the largest traders in stock index futures, and will analyze liquidity provision in futures markets, with a particular focus on electronic trading. Subjects under review include high frequency and algorithmic trading, automatic execution innovations on trading platforms, market access issues and co-location. The staff is also considering rulemaking with respect to exchange colocation and proximity hosting services. The rule would ensure that all otherwise qualified and eligible market participants that seek co-location or proximity hosting services offered by futures exchanges have equal access to such services without barriers that exclude access, or that bar otherwise qualified third-party vendors from providing co-location and/or proximity hosting services. Another purpose of the proposal would be to ensure that futures exchanges that offer co-location or proximity hosting services disclose publically the latencies for each available connectivity option, so that participants can make informed decisions.

The staff is also examining the CFTC’s surveillance capabilities. They will consider automation of the statement of reporting traders in the large trader reporting system, and access to account ownership and control information in the exchange trade registers. According to the staff, these initiatives would increase the timeliness and efficiency of account identification.


The agency staffs are planning a joint study to examine the linkages between correlated assets in the equities (single stocks, mutual funds and ETFs), options and futures markets. The study could partly focus on examining cross-market linkages by analyzing trading in stock index products such as equity index futures, ETFs, equity index options, and equity index OTC derivatives using, to the extent practicable, market data, special call information, and order book data. The report noted that existing cross-market circuit breaker provisions should be re-examined to ensure they continue to be effective in a high-speed electronic trading environment.