The country's financial regulators have delivered their final report on the mysterious May 6 "Flash Crash," in which the Dow plunged 10 percent in just minutes -- and it turns out that a dumb algorithm is partly to blame.
A single large sell order executed by a rather crude software program sent the already-stressed market into a downward spiral.
It was obvious that computerized trading systems clearly played some important role in the Flash Crash, but the Securities and Exchange Commission and Commodity Futures Trading Commission had not gone beyond assigning general blame.
The new report details precisely what happened. A large firm, reportedly Waddell & Reed, sold more than $4 billion of S&P500 futures known as E-Minis. Their sell algorithm only took into account market volume when making trades, not price or time. The algo could only "know" what it was told to know, and because of the unusual market conditions, it sold all of the contracts in 20 minutes.
This large fundamental trader chose to execute this sell program via an automated execution algorithm ("Sell Algorithm") that was programmed to feed orders into the June 2010 E-Mini market to target an execution rate set to 9% of the trading volume calculated over the previous minute, but without regard to price or time.
As the Sell Algorithm went to work, traders bought up the contracts normally, but other algorithms started to pile on, increasing the volume of trades. Because the Sell Algorithm's sell rate was pegged to the volume of the market, it started going faster and faster.
The Sell Algorithm used by the large trader responded to the increased volume by increasing the rate at which it was feeding the orders into the market, even though orders that it already sent to the market were arguably not yet fully absorbed by fundamental buyers or cross-market arbitrageurs. In fact, especially in times of significant volatility, high trading volume is not necessarily a reliable indicator of market liquidity.
The net effect was that the entire order was complete within 20 minutes, and that sent the markets into a panic.