1. Flash Crash Information and Regulatory challenges

2. May 6, 2010

3. May 6, 2010 e-mini

4. E-Mini Narrative (CDT) It was stormy morning, stocks down 13:32 Large seller hedging equity position in the e-mini with a sell program looking for 9% volume participation 13:42 high frequency traders buy and then sell and then sell and sell in the cash market 13:45 “hot potato” passed around increasing volume and program sells 13:45:28 5 second pause in e-mini 13:45:33-13:45:58 prices stabilize 13:46 fundamental buyers back in 14:08 price up to 13:32 level

5. Stock Narrative (EDT) Though e-mini crash stopped by 2:45 sell orders to individual SP500 equities and ETF’s continued to cash market which had been slowed down by very high message traffic “Market Makers” backed away from cash markets leading to trades at “stub quotes” By 3:00, most stocks close to their 2:00 levels Between 2:40 and 3:00 20,000 trades at prices 60% away from their 2:40 level Finra and the exchanges agreed to break such trades

6. HFTs High frequency traders do not necessarily trade so fast, but they do quote fast, with quotes responding to new information (or ?) They are, in part, unofficial market makers providing quotes (liquidity) to those who wish to trade

7. Economics of Market Making Market makers make money by buying at the bid and selling at the higher offer Costs of market making –Opportunity costs –“risk” costs-cost of inventory value fluctuating –Providing quotes to traders with superior information

8. Information and Market Making On average, a market maker loses money when selling to an informed buyer and buying from an informed seller After an informed buy the level of the quotes will change so that buying at the bid and selling at the offer need not lead to a profit Wider spread must be maintained to compensate for losses to informed traders

9. Information The width of the spread between bid and offer is a function of how much difference in information there is between informed traders and those making a market HFTs maximize the amount of information they have by processing information on many different securities Ability to respond to information (low latency) means they can quote tighter spreads

10. Order flow information The information can be directional but can also give an indication of whether there is a lot of potentially informed trade Indication of aggressive selling signals both a direction and the possible presence of informed trade –Drop bid price –Widen spread

11. Market Breakdown If market makers have reduced information and/or indication of very aggressive trading the optimal action may be to stop quoting –Or use stub quotes of bid $.01, $100,000 offered

12. Back to 5/6/10 An apparently very large sell program starts in the E-Mini –9% of previous minutes volume Natural escalation but not a big deal –No limit price attached (unpriced) Who could have private information about the entire economy? but Who would be crazy enough to send in such orders if they did not have information?

13. CME market makers CME market makers build up positive inventory which they seek to hedge, fast and aggressively in the cash markets –SPY, other ETF’s and individual stocks Seek to unload e-mini futures to others who also try to unload as price drops –Increase in volume increases the aggression of the original sell order making market participants more nervous

14. Listed stocks Market makers in listed stocks (NASDAQ and NYSE) trade on Archipelago, BATS, KNIGHT, etc Algos see very aggressive sell orders and attempt to respond to information Flood of orders, order changes and cancellations clog up the system, particularly at NYSE

15. Lack of Information Trades are reported through one system (CTS) while quotes are reported through another (CQS) Massive number of quotes and cancellations means quote information delayed relative to trade information See trades without corresponding quotes –What is going on?

16. Shut it Down Many HFTs decide not to play and wait and see CME calms down but takes longer for information to be processed in the equity markets as quotes are delayed Which finally calm down as well

17. CME v NYSE According to CFTC, HFTs not responsible –They did what they have always done –Both make and take liquidity Appears to have been withdrawal from equity markets So story seems to be different Why?

18. Is my story true Not inconsistent with joint CFTC/SEC report What we really need is more data SEC agrees and actually proposed this before the flash crash

19. SEC information proposals Rule 13h-1 under the authority of 13(h) of the Exchange (34) Act –Requires large traders (2mm shares or $20mm in a day or 10x that in a month) to be registered with unique identifier assigned by SEC –Broker/Dealers must keep record of ID and time stamp of all executions by a large trader –Broker/dealers report large trader information through the Electronic Blue Sheets upon request This will allow SEC to –Assess impact of larger trader activity –Reconstruct trading activity following unusual volatility –Analyze significant market events –Do they have the capacity to analyze the data?

20. Changes to Rule NMS Rule 613 (proposed, not adopted) of Reg NMS would require exchanges to construct repository for data on all trades and quotes by client (not just clearing broker) –Not just trades but quotes –How will SEC process data?

21. Reason for rule change Clearing is handled, for most transactions, at the broker level –Only info reported to FINRA is representing brokers, not clients –Only info on quotes is “top of the book” Best bid and offer and size at best bid and offer SEC can get client information, but requires request and response by broker

22. A lesson If you are trading equities, always use limit orders with reasonable limit prices You may not trade right away, but it can prevent very disadvantageous trades that will not be broken

23. Speculation One company, Nanex (nanex.com), thinks there was and is something more sinister going on flood of message traffic disrupts market –For example quote and quote cancellations at very high volume lead to other machines getting out of the market leaving a wide bid ask spread and source of quotes buys at low bid and sells at high offer

24. Is broader band needed?