By Jon "DRJ" Najarian
It's been a month since the May 6 "flash crash," and we still have no official reason for what happened. But here are three possible, some might even say plausible, scenarios.
- A Very Possible Explanation:
A firm, presumably a hedge fund, executed the trade that was the catalyst for the crash. The only reasonable reason that a fund would do such a thing was that they thought they could manipulate the market. (Remember that Goldman Sachs (GS) said last spring that the high-frequency algorithms stolen from them could be "used to manipulate the markets in a bad way.") And prior to that manipulation the firm purchased a significant amount of put options.
- Perhaps the Most Likely Scenario
A firm that clears hedge funds (we'll call it Firm A), also known as a prime broker, has a fund that was bleeding. That becomes the prime broker's problem when the firm in question has nearly depleted its capital. At such time the broker freezes the hedge fund's accounts and takes measures to limit its exposure. After analyzing the firm's positions, the broker decides how many futures it must sell.
Just before executing the futures hedge, an unscrupulous member of the team executing the trade tells a friend at a rival prime broker or hedge fund (Firm B) that they are about to hit the market with $300 million in futures. The message could be something as innocuous as, "Can't join you for lunch today, got a big meeting at 3."
The person on the receiving end of the email knows they just have moments to hit the market with $300 million sale (also known as program trade), executing a portfolio of stocks that make up the bulk of the S&P futures that are about to be sold. The problem is that, instead of selling $300 million, an extra digit -- not a "B" as in billions versus "M" as in millions -- hits far more stock that is bid for in that millisecond.
Then as the futures trade from Firm A hits, the algos choke do what they are programmed to: shut down. The pressure is too great and as each bid falls, every subsequent bid also falls, creating the proverbial snowball that gets bigger as it gains speed downhill.
- Probably the Least Plausible Reason
A firm that has not properly set fail-safe systems in its algo trading programs picks up a bad price for a millisecond and generates a program trade, selling million of shares in the blink of an eye. Other than the obvious issue that the trade was triggered by bad data, the program is executed as other large trades come in and basically freezes as it was built to do when an obvious error occurs.
There would be a freakishly small chance that all these events could occur at the same time. I always say there are no coincidences on Wall Street, and this would fall squarely in the coincidence category.
What happened on May 6 remains a very severe problem on so many levels. The regulators are clearly overmatched in intelligence, resources, and political clout. Absent some dramatic changes that curb the fractionalization of our financial markets, letting firms skirt the rules and affirmative obligations that market makers have on the CME, CBOE, NYSE, and Nasdaq, I think the results the next time could be disastrous.
Disclosure: No positions