Mechanics Behind the “FLASH CRASH” Presented by Dennis Dick, CFA

May 6 th Flash Crash Contributing Factors: Market Fragmentation Lack of Uniform Circuit Breakers Lack of Displayed Liquidity due to discouragement of displayed liquidity providers Dependence on High Frequency Liquidity No Affirmative Obligations

NYSE LRP Circuit Breaker NYSE Liquidity Replenishment Point (LRP) The NYSE has a circuit breaker system called the LRP Reason – to curb excessive volatility Each stock has it’s own individual LRP Typically a few percentage points away from current price LRP adjusts as price of stock moves Adjusts 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 $ $ $ 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 day At 2:45 ET, selling pressure increased causing number of LRPs to be reached NYSE went to “slow market” on these stocks Unable to access NYSE liquidity during this time Smart routers seek out best available liquidity Other ECNs are thinner Smart 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: PGDate: May 6, 2010 TimeBidSizeAskSizeLastSize 14:43: :44: :45: :45: Reaching LRP 14:46: :46: :46: :46: Trading at bid and ask rapidly 14:46: :47: :47: size bid is taken out 14:47: :47: Trading at bid/ask back and forth 14:47: Low Print 14:47: Bids coming in 14:47: NYSE re-opens 14:48: :50: Starting to trade normal again

ACN sample of Trades on May 6th Time & Sales Ticker: ACNDate: May 6, 2010 TimeBidSizeAskSizeLastSize 14:45: :46: :46: crossed market 14:47: size at 38 is taken out 14:47: :47: :47: :47: lowest trade not busted 14:47: note- busted trades not showing 14:48: :48: somebody bids, immediately hit 14:48: stock re-opens NYSE, crossmkt 14:48: 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 TimeBidSizeAskSizeLastSize 14:45: :45: :46: :46: :46: :46: :46: :46: :46: crossed market 14:46: :47: :47: trading below a penny 14:49: :54:

NYSE LRP to blame? Who’s at fault? Is NYSE at fault for going to a “slow” market Some critics say Yes, but I disagree PG traded no lower that $56 on NYSE NYSE busted zero trades, although some were busted on their ARCA exchange Fault 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 interest Been a few incidents when circuit breakers have been triggered. - Citigroup (C) – June 29 th, trades at 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: WPODate: June 16, 2010 TimeLastSize Time LastSize 15:07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07: :07:

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 crash LRP system of NYSE and lack of similar circuit breakers on other exchanges helps to explain problems with NYSE stocks, BUT Does little to explain why Nasdaq listed issues fell Eg. AAPL fell 50 points in a 15 min span All 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 flow Discourages displayed market making activities Pushes 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 BidSizeAskSize 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 or buy at 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 latency 2. Flash Orders – glimpse of incoming orders 3. Queue jumping – using ISO orders, due to SIP slowness 4. 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 Breakers 2. Lack of Displayed Liquidity 3. Lack of regulation on B/D Internalization 4. HFT Dominance of Public Exchanges, and lack of competition 5. 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 improvement 3) 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.