Mechanics Behind the “FLASH CRASH”

Presented by Dennis Dick, CFA

May 6th Flash Crash

Contributing Factors:

Market FragmentationLack of Uniform Circuit BreakersLack of Displayed Liquidity

• due to discouragement of displayed liquidity providersDependence on High Frequency LiquidityNo Affirmative Obligations

NYSE LRP Circuit Breaker

NYSE Liquidity Replenishment Point (LRP)

The NYSE has a circuit breaker system called the LRPReason – to curb excessive volatilityEach stock has it’s own individual LRPTypically a few percentage points away from current priceLRP adjusts as price of stock movesAdjusts every few seconds

Examples

Examples of LRP’s

Ticker Last LRPBid LRPAsk C $4.05 $3.85 $4.25 Citigroup, LRP Bid is 20 cents below last, LRP Ask is 20 cents above last.

Ticker Last LRPBid LRPAsk GS $146.50 $144.50 $148.50

Ticker Last LRPBid LRPAsk F $13.00 $12.60 $13.40

Price rises/falls to LRP

LRP circuit breaker is reached:

Individual stock converts from an automated market to a manual auction market

Allows the designated market maker to step in and manually trade the order flow

Will manually re-open price of stock at price where supply meets demand (like a typical NYSE open at 9:30 ET).

Stock will then resume trading in automated market

LRPs and May 6th

How did the LRP system affect May 6th:

Trending down most of the dayAt 2:45 ET, selling pressure increased causing number of LRPs to be

reachedNYSE went to “slow market” on these stocksUnable to access NYSE liquidity during this timeSmart routers seek out best available liquidityOther ECNs are thinnerSmart routers swept out ECN limit books, in some cases down to as

little as 1 cent

PG sample of Trades on May 6th

Time & Sales Ticker: PG Date: May 6, 2010

Time Bid Size Ask Size Last Size14:43:00 61.23 7 61.24 3 61.23 214:44:00 60.86 7 60.87 3 60.86 414:45:00 59.60 1 59.73 1 59.61 1514:45:18 59.37 1 59.41 144 59.39 1 Reaching LRP14:46:00 57.26 15 57.36 2 57.26 714:46:30 54.62 1 55.51 12 55.00 314:46:35 52.80 2 53.99 3 53.00 1014:46:40 50.94 1 52.93 6 51.00 1 Trading at bid and ask rapidly14:46:55 50.00 4 51.00 1 50.00 114:47:00 47.63 3 48.96 2 47.63 314:47:04 46.01 119 49.01 2 46.01 7 46.01 size bid is taken out14:47:07 43.51 1 48.71 2 43.90 114:47:10 41.58 1 48.99 7 41.89 1 Trading at bid/ask back and

forth14:47:17 39.37 9 49.06 2 39.37 1 Low Print14:47:21 46.20 6 48.65 6 48.65 2 Bids coming in14:47:42 52.89 22 52.84 14 56.27 1084 NYSE re-opens14:48:08 57.95 7 60.00 2 59.04 114:50:59 62.00 3 62.19 2 62.09 1 Starting to trade normal again

ACN sample of Trades on May 6th

Time & Sales Ticker: ACN Date: May 6, 2010

Time Bid Size Ask Size Last Size14:45:01 40.19 4 40.21 1 40.31 414:46:02 39.89 2 39.90 6 39.73 214:46:31 39.66 2 39.40 1 39.68 2 crossed market14:47:41 38.00 99 39.04 2 38.00 4 size at 38 is taken out14:47:46 32.62 39 36.59 3 34.61 114:47:49 27.70 1 33.24 3 32.12 114:47:50 24.02 1 33.24 4 24.09 114:47:51 1.88 1 33.24 4 17.74 1 lowest trade not busted14:47:55 0.01 4 33.23 3 27.00 1 note- busted trades not

showing14:48:00 28.34 3 33.24 2 33.24 214:48:00 0.01 4 33.49 1 28.34 3 somebody bids, immediately

hit14:48:02 38.88 22 36.69 1 39.00 54 stock re-opens NYSE,

crossmkt14:48:03 39.01 3 39.02 10 39.01 4 stock starts to trade normally

IWF sample of Trades on May 6th

Ticker: IWF (Russell 1000 Growth Index fund) Date: May 6, 2010

Time & Sales

Time Bid Size Ask Size Last Size14:45:00 48.26 14 48.32 1 48.28 114:45:30 47.25 20 47.43 20 47.50 1014:46:00 41.48 3 44.28 3 42.14 114:46:08 35.28 2 42.64 4 36.58 114:46:15 27.56 1 34.98 2 27.56 114:46:17 18.58 1 32.53 4 21.58 114:46:19 0.58 1 20.89 8 3.58 114:46:35 0.10 984 18.24 11 0.10 2314:46:38 19.96 40 18.16 2 19.97 16 crossed market14:46:39 0.10 906 19.87 1 14.65 114:47:27 0.01 22 0.03 97 0.10 214:47:28 0.0001 10 19.97 4 0.0001 1 trading below a penny14:49:57 11.20 12 18.24 19 17.28 114:54:44 38.00 2 38.39 5 38.19 5

NYSE LRP to blame?

Who’s at fault?

Is NYSE at fault for going to a “slow” marketSome critics say Yes, but I disagreePG traded no lower that $56 on NYSENYSE busted zero trades, although some were busted on their

ARCA exchangeFault is that other exchanges didn’t have similar volatility control

systems in place

Uniform Circuit Breakers

SEC Solution: Uniform Circuit Breakers

Pilot program began in mid-June on uniform circuit breakers for S&P 500 stocks

Any stock moving more than 10%, in a five minute period, is halted for 5 minutes on ALL exchanges

Idea – give the affected security time to attract new trading interestBeen a few incidents when circuit breakers have been triggered.

- Citigroup (C) – June 29th, trades at 3.3174 for 8800 shares outside of current market of 3.79 – 3.80 and stock halts for 5 minutes

- Washington Post (WPO) – June 16th

WPO Trades on June 16th

Time & Sales Ticker: WPO Date: June 16, 2010

Time Last Size Time Last Size 15:07:30 452.35 3 15:07:30 453.67 115:07:30 452.79 1 15:07:30 453.67 115:07:30 452.77 1 15:07:30 455.12 215:07:30 452.52 3 15:07:30 455.14 215:07:30 452.79 1 15:07:30 456.91 115:07:30 453.50 1 15:07:30 457.76 115:07:30 452.77 1 15:07:30 457.99 215:07:30 453.68 1 15:07:30 458.72 115:07:30 453.50 1 15:07:30 457.99 515:07:30 453.52 1 15:07:30 456.91 115:07:30 453.69 1 15:07:30 462.84 115:07:30 453.67 1 15:07:30 919.18 415:07:30 454.43 1 15:07:30 919.18 215:07:30 454.51 1 15:07:30 462.85 115:07:30 454.51 1 15:07:30 459.11 115:07:30 455.12 1 15:07:30 929.18 1

Will uniform circuit breakers stop future flash crashes?

With the uniform circuit breakers in place, will future flash crashes be avoided?

It will help, but in a real impact event may just slow impending crashLRP system of NYSE and lack of similar circuit breakers on other

exchanges helps to explain problems with NYSE stocks, BUTDoes little to explain why Nasdaq listed issues fellEg. AAPL fell 50 points in a 15 min spanAll liquidity was accessible

Lack of Displayed Liquidity

Another Contributing Factor: Lack of Displayed Liquidity

Internalization practices where Tier 1 participants internalize uninformed flow and “sub-penny” displayed orders

Increases “toxicity” of public order flowDiscourages displayed market making activitiesPushes market makers to undisplayed venues, leaving us with less

liquidity in “Lit” markets

Broker-Dealer Internalization

What is Broker-dealer Internalization?

When a broker-dealer executes directly against it’s customers orders, or alternatively routes it’s customer’s order to an internalization pool where other market participants will execute against the order

- done off exchange – reported to a TRF – Trade Reporting Facility

Reasons:1. To avoid access fees.2. To receive payment for order flow, from internalizing participant.3. To jump the displayed order queue.

Informed vs Uninformed orders

Informed Orders Those orders on the right side of the market in the short-term, with

regards to the bid-ask spread and basic market making mechanics Internalizers typically do not trade against informed orders

Uninformed Orders Those orders on the wrong side of the market in the short-term, with

regards to the bid-ask spread and basic market making mechanics Internalizers typically execute against uninformed orders Most common type of uninformed order: the Market order

Profit by queue jumping

Consider the following example:

Ticker: C

Bid Size Ask Size4.18 30287 4.19 48298

An internalizer can take the opposite side of their customer’s market buy order and sell the stock at 4.19, jumping ahead of the 4.8M shares offered there.

Similarly, take opposite side of marketable sell orders and buy at 4.18 ahead of queue.

Sub-Pennying

Sub-pennying to improve 605 stats:

The SEC keeps track of price improvement stats in their rule 605 reports:

Internalizers will offer a few sub-pennies of price improvement to improve their 605 stats, and give them justification for jumping the queue (price improvement, and saving access fee).

Eg. Sell C at 4.1899 or buy at 4.1801 in front of displayed NBBO.

Toxic Order Flow on Exchanges

“Toxicity” of Public Order Flow

With the majority of uniformed orders being internalized, order flow on exchanges becomes more toxic.

Discourages displayed market makers Pushes displayed MMs to undisplayed centers Less displayed liquidity Less buyers to absorb selling pressure in market impact event

HFT Dominance of Public Exchanges

Additional Problem, HFT dominance of exchanges:

HFT enjoys specific advantages over other market participants:

1. Co-location – reduces latency2. Flash Orders – glimpse of incoming orders3. Queue jumping – using ISO orders, due to SIP slowness4. Participation in some internalization pools

Dependence on HFT Liquidity

HFT Dominance, and internalization practices have pressed out traditional displayed liquidity providers:

Leaving market with a dependence on HFT Liquidity.Problems:

NO Affirmative Obligations!!When going gets tough….they step away.

Summary

Summary of market structural problems:

1. Lack of Uniform Circuit Breakers2. Lack of Displayed Liquidity3. Lack of regulation on B/D Internalization4. HFT Dominance of Public Exchanges, and lack of competition5. Lack of Affirmative Obligations for current displayed market makers

All these factors led to “Flash Crash”.

Possible Solutions

Possible Solutions:

1) Uniform circuit breakers – Pilot is in place.2) Internalization regulation – Trade At Rule, or minimum amount of

price improvement3) HFT dominance – Level the Playing Field, re-attract traditional

market makers.4) Lack of affirmative obligations – need better than “stub” quotes

- more affirmative obligations for HFT and market making participants.