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October 1, 2010

SEC: 'Panic' Caused Flash Crash

By Peter Chapman

Market makers pulled their bids on May 6, the day of the notorious "flash crash," primarily because prices were falling rapidly. They did not pull their markets because the quote and trade data they were receiving was inaccurate, as was earlier believed.

That's the conclusion of Securities and Exchange Commission staffers who conducted numerous interviews with market makers in stocks and exchange-traded funds.

The staffers presented their findings in a preliminary report to SEC chairman Mary Schapiro and Commodity Futures Trading Commission chairman Gary Gensler at an open meeting on Aug. 11.

"The rapid decline in prices of the e-Mini contract around 2:40 triggered data integrity pauses in trading across a number of automated market-making algorithms even though these price declines were accurate," Gregg Berman, a senior policy adviser in the SEC's Division of Risk, Strategy and Financial Innovation, told Schapiro and Gensler and other members of a joint SEC-CFTC panel.

Market makers previously told regulators they pulled their markets because of "data integrity" issues, but that was generally understood to mean their incoming data was inaccurate. That was not the case on May 6, Berman said.

Gensler was surprised. "It seems there is another principle here: trades that were not erroneous, but at prices that were large deviations from what people had thought," he said.

Rick Ketchum, chairman and chief executive of the Financial Industry Regulatory Authority, was also surprised by the conclusions. "It was a massive market panic reaction," he said.

Berman noted that market-making systems automatically shut down when data is questionable. "One way to identify potential bad data is to look for large rapid price moves, which were in significant abundance on May 6," he said.

In response to the freefall under way that day, some market makers stopped trading altogether and used stub quotes to meet their market-making obligations, Berman said. Others switched to manual trading, but limited their focus to a subset of securities.

The SEC is to soon issue a formal report on the causes of the flash crash.


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