May 6 Stock Fall - Government Releases Preliminary Findings

The staffs of the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues have issued their preliminary findings regarding the May 6 stock market fall. The report states, “We have found no evidence that these events were triggered by ‘fat finger’ errors, computer hacking, or terrorist activity, although we cannot completely rule out these possibilities.” The key portion of the executive summary indicates:

May 6 started with unsettling political and economic news from overseas concerning the European debt crisis that led to growing uncertainty in the financial markets. Increased uncertainty during the day is corroborated by various market data: high volatility; a flight to quality among investors; and the increase in premiums for buying protection against default by the Greek government. This led to a significant, but not extraordinary, down day in early trading for the securities and futures markets.
 
Beginning shortly after 2:30 p.m., however, this overall decline in the financial markets suddenly accelerated. Within a matter of a few minutes, there was an additional decline of more than five percent in both the equity and futures markets. This rapid decline was followed by a similarly rapid recovery. This extreme volatility in the markets suggests the occurrence of a temporary breakdown in the supply of liquidity across the markets.
 
The decline and rebound of prices in major market indexes and individual securities on May 6 was unprecedented in its speed and scope. The whipsawing prices resulted in investors selling at losses during the decline and undermined confidence in the markets. Although evidence concerning the behavior of the financial markets on May 6, 2010 continues to be collected and reviewed, a preliminary picture is beginning to emerge.
 
At this point, we are focusing on the following working hypotheses and findings–
 
(1) possible linkage between the precipitous decline in the prices of stock index products such as index ETFs and the E-mini S&P 500 futures, on the one hand, and simultaneous and subsequent waves of selling in individual securities, on the other, and the extent to which activity in one market may have led the others;
 
(2) a generalized severe mismatch in liquidity, as evinced by sharply lower trading prices and possibly 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 extent to which the liquidity mismatch may have been exacerbated by disparate trading conventions among various exchanges, whereby trading was slowed in one venue, while continuing as normal in another;
 
(4) the need to examine the use of “stub quotes”, which are designed to technically meet a requirement to 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, might have contributed to market instability and a temporary breakdown in orderly trading; and
 
(6) the impact on Exchange Traded Funds (ETFs), which suffered a disproportionate number of broken trades relative to other securities.