The Real Flash Crash Culprits and Meet the Flash Crash Scapegoat (by Jim McTague)

By Jim McTague
Barron's
10/9/10

MEET THE FLASH-CRASH scapegoat. A report by regulators blamed May's spectacular market break on a single trade by a single "mutual fund complex" identified in the press as Waddell & Reed.

This was as ludicrous as blaming Mrs. O'Leary's cow rather than lax building codes for the Great Chicago Fire. The official explanation of the May 6 tumult, which saw the Dow plunge by nearly 1,000 points before largely recovering, does not hold up beyond a reasonable doubt.

In fact, the jargon-encrusted back pages of the report suggest that far greater damage was inflicted on investors that day by their brokerage firms. The brokers abandoned them to the wildfire. Call it progress: Never before have so many lambs been roasted so quickly.

The "Findings Regarding the Market Events of May 6, 2010," by the staffs of the Commodity Futures Trading Commission and the Securities and Exchange Commission,said that although volatility was rising and sellers began to outnumber buyers, a mutual-fund complex initiated a program to sell some 75,000 E-Mini contracts on the Standard & Poor's 500, valued at $4.1 billion, as a hedge to an existing equity position. E-Minis are electronically traded portions of regular futures contracts. The regulators faulted this fund complex for using a program to feed orders into the E-Mini market at an execution rate of 9% of the total trading volume, and without regard to price or time.

HERE'S WHERE THE REGULATORS' story starts to fall apart. CME Group, owner of the exchange where the E-minis trade, said the sell order was consistent with market practices. Furthermore, only half the order had been entered as the market fell. And it had been broken up into small orders—nine out of every 100 coming into the market. In any event, this one trade couldn't have spooked investors because the market is anonymous. Traders didn't see a single, large seller. What they saw was continuous action.

The fact is, high-frequency traders and brokerage houses acting as market makers did more to drive down prices. They stopped buying and started selling.

The brokerage firms' behavior was particularly galling, though by no means illegal. They stopped automatic execution of customer orders, also known as internalization, which on most days accounts for nearly 100% of retail trades.

A brokerage firm will try to match one customer's order with that of another customer in-house. If the firm can't make the trade, it sends the order on to an executing broker. The big ones are Knight Capital, Citadel and UBS. The executing broker will generally take the opposite side of the customer order because retail customers tend to buy high and sell low, so it's easy to make money off them.

In the rare instances when an executing broker demurs, he sends the trade to a dark pool, usually one owned by his firm. (Dark pools are electronic-trading venues where institutional investors trade stocks away from the public stock exchanges.) If the dark pool can't execute the trade, it is sent to one of the stock exchanges. This largely automated process occurs in sub-seconds.

On May 6 when the market fell out of bed, the report says blandly, some of these players reduced executions of sell orders but continued to execute buy orders. In other words, they'd sell stock to a retail customer but wouldn't buy stock from a retail customer. They wanted to get rid of their own inventories, not accumulate more shares. So they sent the customer sell orders onto the swamped stock exchanges.

Here's one measure of the damage: Twenty thousand trades, totaling 5.5 million shares, were executed at a price 60% or more away from pre-Flash-Crash price levels, and thus later were deemed invalid. At least half those were retail orders. And, of course, that says nothing of the countless trades done at discounts of less than 60% but still large.

IT WAS A VICIOUS CYCLE. Retail stop-loss and market orders were converted to limit orders by internalizers prior to routing to the exchanges. A limit order requires the trade to be executed at a specific price, whereas a market order is the best price available. If the limit order wasn't filled because the stock's price had fallen, it was kicked back to the internalizer who, in turn, set a new, lower limit price and resubmitted it. Orders were kicked back multiple times because prices were collapsing so rapidly. They followed the prices down, "eventually reaching unrealistically low bids," as the report puts it.

Brokers meant well. Chris Nagy, managing director of order-routing strategy for TD Ameritrade, told me by e-mail, "In seeking best execution, a broker may use various methods to help ascertain a better price for the client. This tactic is somewhat common to protect unknowing investors from wild price swings, although May 6 was a whole different animal. It's important to note that when this type of strategy is used, it's generally sub-second, and many exchanges don't accept market orders."

SEC Chairman Mary Schapiro expected the report to boost investor confidence. Ba-a-a-h: The goat story is too hard to swallow.