Plunge in US equities remains a mystery

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Plunge in US equities remains a mystery
By Michael Mackenzie and Henny Sender in New York
May 7 2010

The day after $1,000bn was briefly wiped off the market value of US equities, traders were still trying to work out what caused share prices to plunge and then rebound so dramatically in a matter of minutes.

The conventional wisdom held that an incorrectly typed sell order – one that confused “billions” for “millions”, for example – was the likely culprit.

“The trigger for the sell-off was most likely some kind of errant order, a fat-finger typo, which set off a chain reaction of selling,” said Sang Lee, managing principal at Aite Group. “I would be shocked if that was not the case as the fall in stocks was so sudden and extreme.”

However, despite the persistence of this story, officials were struggling to idenfity a specific cause. “We still don’t know what was the initiating signal for the trading activity we saw on Thursday,” said Jeff Wecker, chief executive officer at Lime Brokerage. “The verdict is still out.”

What was clear was the ferocity of the fall. Just before 2.40pm on Thursday, the S&P 500 index, the US equity market’s benchmark, fell from 1,120. Inside six minutes, it bottomed at 1,065.79, a slide of nearly 5 per cent. By 3.00pm, the index was moving above 1,120, although still down 4 per cent on the day before, settling 3.2 per cent lower by the close.

Traders said the day had got off to a gloomy start, with fears that Greece could become the first eurozone country to default on its debt weighing down stock prices. Television images of fighting in Athens reinforced anxieties and encouraged investors to cut risk exposure.

“We already had a significant fear premium in the market and clearly there was some kind of incident which we need to understand,” said William O’Brien, chief executive officer at Direct Edge, one of the four main trading venues for equities.

When the plunge came, traders said it was exacerbated by the rapid-fire computer systems that post prices and execute trades in microseconds. Such trading accounts for the bulk of volume in US equity markets and it served to reinforce a downward move that saw some stocks trade for a penny or less.

Because computers also serve to link markets, the panic spread to currencies and bonds. The yen soared in value against the dollar and the euro. The demand for government debt, a traditional haven during a crisis, soared, pushing the yield on 10-year US Treasury bonds sharply lower.

The situation was made worse, many traders said, by NYSE Euronext’s decision to slow down trading on its trading floor, which sent orders to other venues and intensified the selling.

“This is not a day for the industry to be proud of and when only one exchange slows down or stops trading it does not improve the situation, it exacerbates it,” said Mr OBrien.

One government official said the activity reinforced worries that “the market has outpaced the ability of the infrastructure to handle it. We have detached finance from the real economy and created a monster.”

The selling overwhelmed the market for some stocks, as legitimate bids disappeared, leaving what is called a “stub bid”, or a buy order posted at a penny. In a machine-dominated market such token prices for stocks were duly executed.

Subsequently, the four main trading venues for US stocks – NYSE Euronext, Nasdaq, BATS Trading and Direct Edge – announced the cancellation of trades, executed between 2.40pm and 3.00pm, in which prices deviated sharply.

The Securities and Exchange Commission and the Commodities Futures Trading Commission said they would “review the unusual trading”. Hearings have been scheduled for Tuesday before the House financial services subcommittee on capital markets.

Hedge funds held conference calls to explain the situation to their investors. Algebris Investments in London, which is down 4.5 per cent this month, told clients it was scaling back its positions and adding to hedges by buying credit insurance on companies and taking short positions on European stock indices.