The big SEC/Commodity Futures Trading Commission report that came out two weeks ago pinned the blame for starting the May 6 Flash Crash on a single trade by a Kansas firm. The story went like this: the firm used an algorithm that traded a type of S&P future called an E-mini based on the volume of the market, without taking into account price or timing. As the trade began, high-frequency traders jumped into the market and -- for a set of complex reasons -- the volume exploded, leading the algorithm to accelerate its own trading. The speed spooked the market and because other futures are pegged to E-minis, everything went haywire.
This was a neat narrative, but now it is encountering opposition. The firm that people pegged as making the trade, Waddell & Reed, released its own trading data to the once-obscure research firm Nanex, which has made a name for itself analyzing the Flash Crash. They released a report, which sometime Atlantic Technology Channel author, Joe Flood, glossed for his day job at the institutional investing magazine, ai5000. The short story? The Waddell and SEC/CFTC stories just don't match up.
Since the Crash, Waddell's stock price has dropped more than 20%, and the company has been reduced to sending out BP-esque missives about how it didn't intentionally to blow up the world. But in hopes of clearing its name, Waddell provided Nanex with its own trading data from the Flash Crash (with Barclay's certifying the authenticity of the data).
With the new data in hand, Nanex has concluded that the regulators' report just doesn't fit the timeline: most of Waddell's selling took place after the Crash, during a rebound. "The algorithm was very well behaved," reads a Nanex report released this afternoon. "It was careful not to impact the market...And when prices moved down sharply, it would stop completely."
The Crash, says Nanex, was actually caused by the aggressive reselling of those contracts by other firms (Nanex doesn't say what kind of firms, but the SEC-CFTC report identifies them as high-frequency traders). "Rather than making sure the sale would not impact the market, they did quite the opposite: they slammed the market with 2,000 or more contracts as fast as they could...As time passed, the aggressiveness only increased, with these violent selling events occurring more often, until finally the e-Mini circuit breaker kicked in and paused trading for 5 seconds, ending the market slide."
CFTC Commissioner Bart Chilton says that the reselling of the E-Mini's played a role in the crash, but he's confident in the report's finding that the Waddell trade started the downward spiral. "We looked at hundreds of thousands of trades, and this is the one that stands out. It was just one domino, but it was the domino that started the decline. It didn't fall any harder than any others, but it was first one to fall....Any stories that are trying to pin everything one one culprit like in a whodunnit mystery [aren't fair] but this trade was the start of things."
The argument here is not just a technical one. There are important policy and rhetorical consequences to either story. If the Flash Crash was caused by one dumb trade, regulation might be beside the point; it's hard to regulate against incompetence. But if Nanex is right and high-frequency traders turned a mundane trade into, well, the Flash Crash, then perhaps there is a better argument for limiting some algorithmic trading behaviors.
In any case, maybe we should still keep the Flash Crash case file open... at least until we have another one with which to compare it.