Flash Crash Report Points Finger at Wrong Source of Big Trade That Went Bad

The joint Securities Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) report on the Flash Crash that was published three weeks ago laid out a controversial but fairly clear narrative of what went wrong on May 6th, when the Dow plunged hundreds of points in the blink of an eye, then (mostly) recovered just as quickly. According to the report, an unnamed “mutual fund complex” known to be Kansas-based Waddell & Reed executed a trade to sell 75,000 E-Mini contracts, a kind of future for the S&P 500. Unfortunately, Waddell’s algorithm was too simplistic, piling more and more sales orders onto an already saturated market, and kicking off an ugly chain of rapid price changes and liquidity evaporation that drove that market into a tailspin.

Some elements of this story have already been challenged by market research firm Nanex, which has been deeply involved in investigating the crash and received raw data from the trade itself. But now sources are confirming a major hole in the report’s underlying story. First, Waddell & Reed can’t directly trade E-Minis. E-Minis are a product of the Chicago Mercantile Exchange and can only be traded on that exchange, and Waddell & Reed is not a member. Like most mutual funds, they rely on a “clearing member” of the exchange to route their trades.

More importantly, in the case of the fateful trade it was not actually Waddell’s own algorithm that executed the trade, as implied by the SEC-CFTC report, but that of its broker, Barclay’s Capital. Further complicating matters, researchers and people close to the trade are disagreeing with the report’s characterization of the algorithm that executed the trade, pointing out that it has been many times for much larger trades with no similar fallout.

“Based on our data, this was actually a very good algorithm,” says Nanex founder Eric Hunsader, who has analyzed the trade data. “It’s portrayed [in the report] as a very simple algorithm, but you can clearly see that it did take into account things like price—if it hadn’t, you could have really seen a market collapse…What really caused the collapse was firms re-selling these contracts incredibly quickly and just drying up all the liquidity.”

The SEC-CFTC report makes no mention of any executing broker or other source of the algorithm, pinning the blame for the trade squarely on the “mutual fund complex” known to be Waddell & Reed. But in a statement from a CFTC spokesman, the commission acknowledged that there was an executing broker responsible for handling the trade. The spokesman went on to say that the CFTC “interviewed both the large trader and the executing broker about the algorithm and is confident of the description in the joint report.”

When asked if investigators interviewed the Barclay’s engineers responsible for handling the executing algorithm before concluding the investigation and filing the report, the CFTC declined further comment.

The SEC and Barclay’s both declined immediate comment, and Waddell & Reed released the following statement: “Following the recent release of the regulatory report on the “flash crash,” many market observers have noted that the events of May 6 involve multiple issues that transcend the actions of any single market participant. We agree with those observations.”

Stay tuned for more developments.