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114-620: Examples of flash crashes that have occurred: This type of event occurred on May 6, 2010 in the United States. A $ 4.1 billion trade on the New York Stock Exchange (NYSE) resulted in a loss to the Dow Jones Industrial Average of over 1,000 points and then a rise to approximately previous value, all over about fifteen minutes. The mechanism causing the event has been heavily researched and

228-474: A feedback mechanism that forces even more market makers out. This cascading effect has caused hundreds of liquidity-induced crashes in the past, the flash crash being one (major) example of it. However, independent studies published in 2013 strongly disputed the claim that one hour before its collapse in 2010, the stock market registered the highest reading of "toxic order imbalance" in previous history. In particular, in 2011 Andersen and Bondarenko conducted

342-727: A 2011 op-ed in The New York Times a year after the Flash Crash, sharply critical of what they perceived to be the SEC's apparent lack of action to prevent a recurrence. In 2011 high-frequency traders moved away from the stock market as there had been lower volatility and volume. The combined average daily trading volume in the New York Stock Exchange and Nasdaq Stock Market in the first four months of 2011 fell 15% from 2010, to an average of 6.3 billion shares

456-517: A 36-year-old small-time trader who worked from his parents' modest stucco house in suburban west London for sparking a trillion-dollar stock market crash is "a little bit like blaming lightning for starting a fire" and that the investigation was lengthened because regulators used "bicycles to try and catch Ferraris". Furthermore, he concluded that by April 2015, traders can still manipulate and impact markets in spite of regulators and banks' new, improved monitoring of automated trade systems. In May 2014,

570-588: A Bloomberg, a printer, a fax, and three TVs on the wall with several large clocks. A better measure of the inadequacy of the current mélange of IT antiquities is that the SEC/CFTC report on the May 6 crash was released on September 30, 2010. Taking nearly five months to analyze the wildest ever five minutes of market data is unacceptable. CFTC Chair Gensler specifically blamed the delay on the “enormous” effort to collect and analyze data. What an enormous mess it is. Nanex ,

684-513: A CDO—usually a special purpose entity—is typically a corporation established outside the United States to avoid being subject to U.S. federal income taxation on its global income. These corporations must restrict their activities to avoid U.S. tax liabilities; corporations that are deemed to engage in trade or business in the U.S. will be subject to federal taxation. Foreign corporations that only invest in and hold portfolios of U.S. stock and debt securities are not. Investing, unlike trading or dealing,

798-488: A CFTC report concluded that high-frequency traders "did not cause the Flash Crash, but contributed to it by demanding immediacy ahead of other market participants". Some recent peer-reviewed research shows that flash crashes are not isolated occurrences, but have occurred quite often. Gao and Mizrach studied US equities over the period of 1993–2011. They show that breakdowns in market quality (such as flash crashes) have occurred in every year they examined and that, apart from

912-482: A buyer; it never crossed the bid/ask spread. That means that none of the 6,438 trades were executed by hitting a bid. [...] [S]tatements from page 36 of Kirilenko's paper cast serious doubt on the credibility of their analysis. [...] It is widely believed that the "sell program" refers to the algo selling the W&;R contracts. However, based on the statements above, this cannot be true. The sell program must be referring to

1026-417: A comprehensive investigation of the two main versions of VPIN used by its creators, one based on the standard tick-rule (or TR-VPIN) and the other based on Bulk Volume Classification (or BVC-VPIN). They find that the value of TR-VPIN (BVC-VPIN) one hour before the crash "was surpassed on 71 (189) preceding days, constituting 11.7% (31.2%) of the pre-crash sample". Similarly, the value of TR-VPIN (BVC-VPIN) at

1140-691: A day. Trading activities declined throughout 2011, with April's daily average of 5.8 billion shares marking the lowest month since May 2008. Sharp movements in stock prices, which were frequent during the period from 2008 to the first half of 2010, were in a decline in the Chicago Board Options Exchange volatility index, the VIX, which fell to its lowest level in April 2011 since July 2007. These volumes of trading activity in 2011, to some degree, were regarded as more natural levels than during

1254-422: A different algo, or Kirilenko's analysis is fundamentally flawed, because the paper incorrectly identifies trades that hit the bid as executions by the W&R algo. As of July 2011, only one theory on the causes of the flash crash was published by a Journal Citation Reports indexed, peer-reviewed scientific journal. It was reported in 2011 that one hour before its collapse in 2010, the stock market registered

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1368-537: A flash crash occurred on the Singapore Exchange which wiped out $ 6.9 billion in capitalization and saw some stocks lose up to 87 percent of their value. The crash resulted in new regulations being announced in August 2014. Minimum trading prices of 0.20 cents per share would be introduced, short positions would be required to be reported, and a 5 percent collateral levy implemented. The exchange said

1482-576: A flash crash was seen in the value USDJPY and AUDUSD, which dropped more than 4% in a few minutes. It was the USD lowest level against the Yen and AUD against USD since March 2009. The USDJPY and AUDUSD recovered much of its value in the next few minutes. It was speculated that the flash crash may have been due to Apple reporting reduced sales forecast in China but this seems unlikely as the report came out an hour before

1596-531: A given stock at a penny. A stub quote is essentially a place holder quote because that quote would never—it is thought—be reached. When a market order is seeking liquidity and the only liquidity available is a penny-priced stub quote, the market order, by its terms, will execute against the stub quote. In this respect, automated trading systems will follow their coded logic regardless of outcome, while human involvement likely would have prevented these orders from executing at absurd prices. As noted below, we are reviewing

1710-539: A global CDO market of over US$ 1.5 trillion. CDO was the fastest-growing sector of the structured finance market between 2003 and 2006; the number of CDO tranches issued in 2006 (9,278) was almost twice the number of tranches issued in 2005 (4,706). CDOs, like mortgage-backed securities, were financed with debt, enhancing their profits but also enhancing losses if the market reversed course. Subprime mortgages had been financed by mortgage-backed securities (MBS). Like CDOs, MBSs were structured into tranches, but issuers of

1824-569: A joint report titled "Findings Regarding the Market Events of May 6, 2010" identifying the sequence of events leading to the flash crash. The joint 2010 report "portrayed a market so fragmented and fragile that a single large trade could send stocks into a sudden spiral", and detailed how a large mutual fund firm selling an unusually large number of E-Mini S&P contracts first exhausted available buyers, and then how high-frequency traders (HFT) started aggressively selling, accelerating

1938-450: A large basket of European stocks over the market. Later in the afternoon Nasdaq confirmed that the flash crash was due to a very large accidental sell order by a market participant, a so-called fat-finger error . Nasdaq would not comment which market participant it was. Later in the day Citigroup admitted that the crash was caused by "an error when inputting a transaction" by one of its traders at their London trading desk. In October 2013,

2052-417: A large fundamental trader (known to be Waddell & Reed Financial Inc. ) "initiated a sell program to sell a total of 75,000 E-Mini S&P contracts (valued at approximately $ 4.1 billion) as a hedge to an existing equity position ". The report says that this was an unusually large position and that the computer algorithm the trader used to trade the position was set to "target an execution rate set to 9% of

2166-469: A leading firm specialized in the analysis of high-frequency data, also pointed out to several inconsistencies in the CFTC study: Based on interviews and our own independent matching of the 6,438 W&R executions to the 147,577 CME executions during that time, we know for certain that the algorithm used by W&R never took nor required liquidity. It always posted sell orders above the market and waited for

2280-577: A loan in Bakersfield, California, where "a Mexican strawberry picker with an income of $ 14,000 and no English was lent every penny he needed to buy a house of $ 724,000". As two-year " teaser" mortgage rates —common with those that made home purchases like this possible—expired, mortgage payments skyrocketed. Refinancing to lower mortgage payment was no longer available since it depended on rising home prices. Mezzanine tranches started to lose value in 2007; by mid year AA tranches were worth only 70 cents on

2394-474: A low of $ 3,217 a metric ton before rebounding quickly. The U.S. dollar tumbled against the yen on March 16, 2011, falling 5% in minutes, one of its biggest moves ever. According to a former cocoa trader: "The electronic platform is too fast; it doesn't slow things down like humans would." Collateralized debt obligation A collateralized debt obligation ( CDO ) is a type of structured asset-backed security (ABS). Originally developed as instruments for

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2508-525: A number of critics stated that blaming a single order (from Waddell & Reed ) for triggering the event was disingenuous. Most prominent of all, the CME issued, within 24 hours, a rare press release in which it argued against the SEC/CFTC explanation: Futures and options markets are hedging and risk transfer markets. The report references a series of bona fide hedging transactions, totaling 75,000 contracts, entered into by an institutional asset manager to hedge

2622-434: A penny likely was attributable to the use of a practice called "stub quoting." When a market order is submitted for a stock, if available liquidity has already been taken out, the market order will seek the next available liquidity, regardless of price. When a market maker’s liquidity has been exhausted, or if it is unwilling to provide liquidity, it may at that time submit what is called a stub quote—for example, an offer to buy

2736-450: A portion of the risk in its $ 75 billion investment portfolio in response to global economic events and the fundamentally deteriorating market conditions that day. The 75,000 contracts represented 1.3% of the total E-Mini S&P 500 volume of 5.7 million contracts on May 6 and less than 9% of the volume during the time period in which the orders were executed. The prevailing market sentiment was evident well before these orders were placed, and

2850-618: A result of large traders seeking to buy or sell quantities larger than intermediaries are willing to temporarily hold, and simultaneously long-term suppliers of liquidity are not forthcoming even if significant price concessions are offered. Recent research on dynamical complex networks published in Nature Physics (2013) suggests that the 2010 Flash Crash may be an example of the "avoided transition" phenomenon in network systems with critical behavior. In April 2015, Navinder Singh Sarao, an autistic London-based point-and-click trader,

2964-457: A setback when rating agencies "were forced to downgrade hundreds" of the securities, but sales of CDOs grew—from $ 69 billion in 2000 to around $ 500 billion in 2006. From 2004 through 2007, $ 1.4 trillion worth of CDOs were issued. Early CDOs were diversified, and might include everything from aircraft lease-equipment debt, manufactured housing loans, to student loans and credit card debt. The diversification of borrowers in these "multisector CDOs"

3078-570: A significant effect on regulatory proposals put forward to prevent another flash crash. According to Bloomberg, the VPIN metric is the subject of a pending patent application filed by the paper's three authors, Maureen O'Hara and David Easley of Cornell University , and Marcos Lopez de Prado , of Tudor Investment Corporation . A study of VPIN by scientists from the Lawrence Berkeley National Laboratory cited

3192-509: A £50,000 bail with a full extradition hearing scheduled for September with the US Department of Justice. Sarao and his company, Nav Sarao Futures Limited, allegedly made more than $ 40 million in profit from trading from 2009 to 2015. During extradition proceedings he was represented by Richard Egan of Tuckers Solicitors . As of 2017 Sarao's lawyers claim that all of his assets were stolen or otherwise lost in bad investments. Sarao

3306-510: Is "sliced" into sections known as "tranches" , which "catch" the cash flow of interest and principal payments in sequence based on seniority. If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most "junior" tranches suffer losses first. The last to lose payment from default are the safest, most senior tranches. Consequently, coupon payments (and interest rates) vary by tranche with

3420-454: Is finding buyers for the riskier pieces at the bottom of the pile. The way mortgage securities are structured, if you cannot find buyers for the lower-rated slices, the rest of the pool cannot be sold. To deal with the problem, investment bankers "recycled" the mezzanine tranches, selling them to underwriters making more structured securities—CDOs. Though the pool that made up the CDO collateral might be overwhelmingly mezzanine tranches, most of

3534-550: Is in dispute. On April 21, 2015, the U.S. Department of Justice laid "22 criminal counts, including fraud and market manipulation" against Navinder Singh Sarao , a trader. Among the charges included was the use of spoofing algorithms. On June 22, 2017, the price of Ethereum , the second-largest digital cryptocurrency , dropped from more than $ 300 to as low as $ 0.10 in minutes at GDAX exchange. Suspected for market manipulation or an account takeover at first, later investigation by GDAX claimed no indication of wrongdoing. The crash

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3648-438: Is not considered to be a trade or business, regardless of its volume or frequency. In addition, a safe harbor protects CDO issuers that do trade actively in securities, even though trading in securities technically is a business, provided the issuer's activities do not cause it to be viewed as a dealer in securities or engaged in a banking, lending or similar businesses. CDOs are generally taxable as debt instruments except for

3762-549: The Chicago Board Options Exchange sent a message saying that NYSE Arca was "out of NBBO" ( National best bid and offer ). The Chicago Board Options Exchange, NASDAQ, NASDAQ OMX BX and BATS Exchange all declared self-help against NYSE Arca. SEC Chairwoman Mary Schapiro testified that "stub quotes" may have played a role in certain stocks that traded for 1 cent a share. According to Schapiro: The absurd result of valuable stocks being executed for

3876-482: The Community Reinvestment Act was enacted to address historical discrimination in lending, such as ' redlining '. The Act encouraged commercial banks and savings associations (Savings and loan banks) to meet the needs of borrowers in all segments of their communities, including low- and moderate-income neighborhoods (who might earlier have been thought of as too risky for home loans). In 1977,

3990-573: The Great Recession . Gretchen Morgenson described the securities as "a sort of secret refuse heap for toxic mortgages [that] created even more demand for bad loans from wanton lenders." CDOs prolonged the mania, vastly amplifying the losses that investors would suffer and ballooning the amounts of taxpayer money that would be required to rescue companies like Citigroup and the American International Group." ... In

4104-551: The IMF 's former chief economist Raghuram Rajan warned that rather than reducing risk through diversification, CDOs and other derivatives spread risk and uncertainty about the value of the underlying assets more widely. During and after the crisis, criticism of the CDO market was more vocal. According to the radio documentary "Giant Pool of Money", it was the strong demand for MBS and CDO that drove down home lending standards. Mortgages were needed for collateral and by approximately 2003,

4218-459: The S&;P 500 index) also down approximately 3%. Still lacking sufficient demand from fundamental buyers or cross-market arbitrageurs, HFTs began to quickly buy and then resell contracts to each other—generating a “hot-potato” volume effect as the same positions were rapidly passed back and forth. Between 2:45:13 and 2:45:27, HFTs traded over 27,000 contracts, which accounted for about 49 percent of

4332-643: The Washington Post Company 's shares were halted for five minutes after it became the first stock to trigger the new circuit breakers. Three erroneous NYSE Arca trades were said to have been the cause of the share price jump. On May 6, the markets only broke trades that were more than 60 percent away from the reference price in a process that was not transparent to market participants. A list of 'winners' and 'losers' created by this arbitrary measure has never been made public. By establishing clear and transparent standards for breaking erroneous trades,

4446-430: The crash of 2:45 or simply the flash crash , was a United States trillion-dollar flash crash (a type of stock market crash ) which started at 2:32 p.m. EDT and lasted for approximately 36 minutes. Stock indices, such as the S&P 500 , Dow Jones Industrial Average and Nasdaq Composite , collapsed and rebounded very rapidly. The Dow Jones Industrial Average had its second biggest intraday point decline (from

4560-562: The 1970s, private companies began mortgage asset securitization by creating private mortgage pools. In 1974, the Equal Credit Opportunity Act in the United States imposed heavy sanctions for financial institutions found guilty of discrimination on the basis of race, color, religion, national origin, sex, marital status, or age This led to a more open policy of giving loans (sometimes subprime) by banks, guaranteed in most cases by Fannie Mae and Freddie Mac. In 1977,

4674-508: The 2007–2009 subprime mortgage crisis . In 1970, the US government-backed mortgage guarantor Ginnie Mae created the first MBS ( mortgage-backed security ), based on FHA and VA mortgages. It guaranteed these MBSs. This would be the precursor to CDOs that would be created two decades later. In 1971, Freddie Mac issued its first Mortgage Participation Certificate. This was the first mortgage-backed security made of ordinary mortgages. All through

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4788-492: The 2011 conclusions of Easley, Lopez de Prado and O'Hara for VPIN on S&P 500 futures but provided no independent confirmation for the claim that VPIN reached its historical high one hour before the crash: The Chief Economist of the Commodity Futures Trading Commission and several academic economists published a working paper containing a review and empirical analysis of trade data from

4902-546: The 404 New York Stock Exchange listed S&P 500 stocks. The first circuit breakers were installed to only 5 of the S&;P 500 companies on Friday, June 11, to experiment with the circuit breakers. The five stocks were EOG Resources, Genuine Parts, Harley Davidson, Ryder System and Zimmer Holdings. By Monday, June 14, 44 had them. By Tuesday, June 15, the number had grown to 223, and by Wednesday, June 16, all 404 companies had circuit breakers installed. On June 16, 2010, trading in

5016-553: The E-Mini was paused for five seconds when the Chicago Mercantile Exchange ('CME') Stop Logic Functionality was triggered in order to prevent a cascade of further price declines. In that short period of time, sell-side pressure in the E-Mini was partly alleviated and buy-side interest increased. When trading resumed at 2:45:33 p.m., prices stabilized and shortly thereafter, the E-Mini began to recover, followed by

5130-528: The European STOXX 600 2.2%. At their lowest point around €300bn or $ 315bn had been erased from the markets. The indices quickly rebounded to levels at or slightly below what it was before the crash. A spokesperson for Nasdaq said the crash was not because of internal server errors or hacker attacks. Nasdaq stated that trades done during the crash would not be cancelled on the exchanges that it operates. There were rumors that Citigroup had accidentally sold

5244-670: The Flash Crash. The authors examined the characteristics and activities of buyers and sellers in the Flash Crash and determined that a large seller, a mutual fund firm, exhausted available fundamental buyers and then triggered a cascade of selling by intermediaries, particularly high-frequency trading firms. Like the SEC/CFTC report described earlier, the authors call this cascade of selling "hot potato trading", as high-frequency firms rapidly acquired and then liquidated positions among themselves at steadily declining prices. The authors conclude: Based on our analysis, we believe that High Frequency Traders exhibit trading patterns inconsistent with

5358-452: The SPY". After a short while, as market participants had "time to react and verify the integrity of their data and systems, buy-side and sell-side interest returned and an orderly price discovery process began to function", and by 3:00 p.m., most stocks "had reverted back to trading at prices reflecting true consensus values". A few hours after the release of the 104-page SEC/CFTC 2010 report,

5472-636: The United States National Market System for equity securities . The Reg NMS, promulgated and described by the United States Securities and Exchange Commission , was intended to assure that investors received the best price executions for their orders by encouraging competition in the marketplace, but created attractive new opportunities for high-frequency-traders. Activities such as spoofing , layering and front running were banned by 2015. This rule

5586-489: The Volume-Synchronized Probability of Informed Trading (VPIN) Flow Toxicity metric, which delivered a real-time estimate of the conditions under which liquidity is being provided. If the order imbalance becomes too toxic, market makers are forced out of the market. As they withdraw, liquidity disappears, which increases even more the concentration of toxic flow in the overall volume, which triggers

5700-491: The Wall Street clients in hopes of getting hired by them for a multiple increase in pay. ... Their [the rating agencies] failure to recognize that mortgage underwriting standards had decayed or to account for the possibility that real estate prices could decline completely undermined the ratings agencies' models and undercut their ability to estimate losses that these securities might generate." Michael Lewis also pronounced

5814-733: The actual crash. The lows reported on USDJPY also varied with Reuters reporting a low of 104.90 on USDJPY while FXMarketAPI reported a low of 104.45. On May 2, 2022, from 9:56 to 10:01 CET the Swedish OMXS30 index dropped 6.8%, the Norwegian OBX 4.1%, the Danish OMXC25 -6.7% and the Finnish OMXH25 -7.5%. Other European indices dropped too, although not as severely as the Nordic exchanges. The German DAX dropped 1.6% and

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5928-422: The basic principle is the same. A CDO is a type of asset-backed security . To create a CDO, a corporate entity is constructed to hold assets as collateral backing packages of cash flows which are sold to investors. A sequence in constructing a CDO is: A common analogy compares the cash flow from the CDO's portfolio of securities (say mortgage payments from mortgage-backed bonds) to water flowing into cups of

6042-488: The corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a probability of default (PD) derived from ratings on those bonds or assets. The CDO

6156-484: The day, the equity market began to fall rapidly, dropping an additional 600 points in 5 minutes for a loss of nearly 1,000 points for the day by 2:47 p.m. Twenty minutes later, by 3:07 p.m., the market had regained most of the 600-point drop. At the time of the flash crash, in May 2010, high-frequency traders were taking advantage of unintended consequences of the consolidation of the U.S. financial regulations into Regulation NMS , designed to modernize and strengthen

6270-658: The diversified consumer loans as collateral. By 2004, mortgage-backed securities accounted for more than half of the collateral in CDOs. According to the Financial Crisis Inquiry Report , "the CDO became the engine that powered the mortgage supply chain", promoting an increase in demand for mortgage-backed securities without which lenders would have "had less reason to push so hard to make" non-prime loans. CDOs not only bought crucial tranches of subprime mortgage-backed securities, they provided cash for

6384-534: The dollar. By October triple-A tranches had started to fall. Regional diversification notwithstanding, the mortgage backed securities turned out to be highly correlated. Big CDO arrangers like Citigroup , Merrill Lynch and UBS experienced some of the biggest losses, as did financial guaranteers such as AIG , Ambac , MBIA . An early indicator of the crisis came in July 2007 when rating agencies made unprecedented mass downgrades of mortgage-related securities (by

6498-523: The early 2000s, the debt underpinning CDOs was generally diversified, but by 2006–2007—when the CDO market grew to hundreds of billions of dollars—this had changed. CDO collateral became dominated by high risk ( BBB or A ) tranches recycled from other asset-backed securities, whose assets were usually subprime mortgages . These CDOs have been called "the engine that powered the mortgage supply chain" for subprime mortgages, and are credited with giving lenders greater incentive to make subprime loans, leading to

6612-472: The effect of the mutual fund's selling and contributing to the sharp price declines that day. The SEC and CFTC joint 2010 report itself says that "May 6 started as an unusually turbulent day for the markets" and that by the early afternoon "broadly negative market sentiment was already affecting an increase in the price volatility of some individual securities". At 2:32 p.m. (EDT), against a "backdrop of unusually high volatility and thinning liquidity" that day,

6726-473: The end of 2008 91% of CDO securities were downgraded ), and two highly leveraged Bear Stearns hedge funds holding MBSs and CDOs collapsed. Investors were informed by Bear Stearns that they would get little if any of their money back. In October and November the CEOs of Merrill Lynch and Citigroup resigned after reporting multibillion-dollar losses and CDO downgrades. As the global market for CDOs dried up

6840-588: The equity layer tranches were paid last in the sequence and there was not sufficient cash flow from the underlying subprime mortgages (many of which defaulted) to trickle down to the equity layers. Ultimately the challenge is in accurately quantifying the risk and return characteristics of these constructs. Since the introduction of David Li's 2001 model, there have been material advances in techniques that more accurately model dynamics for these complex securities. CDO refers to several different types of products. The primary classifications are as follows: The issuer of

6954-515: The financial crisis and its aftermath. Some argued that those lofty levels of trading activity were never an accurate picture of demand among investors. It was a reflection of computer-driven traders passing securities back and forth between day-trading hedge funds. The flash crash exposed this phantom liquidity. In 2011 high-frequency trading firms became increasingly active in markets like futures and currencies, where volatility remains high. In 2011 trades by high-frequency traders accounted for 28% of

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7068-535: The financial crisis, such problems have declined since the introduction of Reg NMS . They also show that 2010, while infamous for the flash crash, was not a year with an inordinate number of breakdowns in market quality. On May 6, 2010, U.S. stock markets opened and the Dow was down, and trended that way for most of the day on worries about the debt crisis in Greece . At 2:42 p.m., with the Dow down more than 300 points for

7182-481: The first quarter of 2008 alone, credit rating agencies announced 4,485 downgrades of CDOs. At least some analysts complained the agencies over-relied on computer models with imprecise inputs, failed to account adequately for large risks (like a nationwide collapse of housing values), and assumed the risk of the low rated tranches that made up CDOs would be diluted when in fact the mortgage risks were highly correlated, and when one mortgage defaulted, many did, affected by

7296-514: The first weekend, regulators had discounted the possibility of trader error and focused on automated trades conducted on exchanges other than the NYSE . However, CME Group , a large futures exchange , stated that, insofar as stock index futures traded on CME Group were concerned, its investigation found no evidence for this, or that high-frequency trading played a role, and in fact concluded that automated trading had contributed to market stability during

7410-544: The following days, helped by a bailout package in Europe to help save the euro. The S&P 500 erased all losses within a week, but selling soon took over again and the indices reached lower depths within two weeks. The NASDAQ released their timeline of the anomalies during U.S. Congressional House Subcommittee on Capital Markets and Government-Sponsored Enterprises hearings on the flash crash. NASDAQ's timeline indicates that NYSE Arca may have played an early role and that

7524-455: The government's technological capabilities and inability to study today's markets. Leinweber wrote: The heads of the SEC and CFTC often point out that they are running an IT museum. They have photographic evidence to prove it—the highest-tech background that The New York Times (on September 21, 2010) could find for a photo of Gregg Berman, the SEC’s point man on the flash, was a corner with five PCs,

7638-456: The highest reading of "toxic order imbalance" in previous history. The authors of this 2011 paper apply widely accepted market microstructure models to understand the behavior of prices in the minutes and hours prior to the crash. According to this paper, "order flow toxicity" can be measured as the probability that informed traders (e.g., hedge funds ) adversely select uninformed traders (e.g., market makers ). For that purpose, they developed

7752-460: The incident, the U.S. Department of Justice laid 22 criminal counts, including fraud and market manipulation against Navinder Singh Sarao, a British Indian financial trader. Among the charges included was the use of spoofing algorithms; just prior to the flash crash, he placed orders for thousands of E-mini S&P 500 stock index futures contracts which he planned on canceling later. These orders amounting to about "$ 200 million worth of bets that

7866-584: The initial funding of the securities. Between 2003 and 2007, Wall Street issued almost $ 700 billion in CDOs that included mortgage-backed securities as collateral. Despite this loss of diversification, CDO tranches were given the same proportion of high ratings by rating agencies on the grounds that mortgages were diversified by region and so "uncorrelated" —though those ratings were lowered after mortgage holders began to default. The rise of "ratings arbitrage"—i.e., pooling low-rated tranches to make CDOs—helped push sales of CDOs to about $ 500 billion in 2006, with

7980-428: The investment bank Salomon Brothers created a "private label" MBS (mortgage backed security)—one that did not involve government-sponsored enterprise (GSE) mortgages. However, it failed in the marketplace. Subsequently, Lewis Ranieri ( Salomon ) and Larry Fink ( First Boston ) invented the idea of securitization ; different mortgages were pooled together and this pool was then sliced into tranches , each of which

8094-412: The investment depends on the assumptions and methods used to define the risk and return of the tranches. CDOs, like all asset-backed securities , enable the originators of the underlying assets to pass credit risk to another institution or to individual investors. Thus investors must understand how the risk for CDOs is calculated. The issuer of the CDO, typically an investment bank, earns a commission at

8208-413: The investors where senior tranches were filled first and overflowing cash flowed to junior tranches, then equity tranches. If a large portion of the mortgages enter default, there is insufficient cash flow to fill all these cups and equity tranche investors face the losses first. The risk and return for a CDO investor depends both on how the tranches are defined, and on the underlying assets. In particular,

8322-756: The low-rated slices Wall Street couldn't sell on its own." Other factors explaining the popularity of CDOs include: In the summer of 2006, the Case–Shiller index of house prices peaked. In California, home prices had more than doubled since 2000 and median house prices in Los Angeles had risen to ten times the median annual income. To entice those with low and moderate income to sign up for mortgages, down payments and income documentation were often dispensed with and interest and principal payments were often deferred upon request. Journalist Michael Lewis gave as an example of unsustainable underwriting practices

8436-743: The major market indexes dropped by over 9% (including a roughly 7% decline in a roughly 15-minute span at approximately 2:45 p.m., on May 6, 2010) before a partial rebound. Temporarily, $ 1 trillion in market value disappeared. While stock markets do crash, immediate rebounds are unprecedented. The stocks of eight major companies in the S&P 500 fell to one cent per share for a short time, including Accenture , CenterPoint Energy and Exelon ; while other stocks, including Sotheby's , Apple Inc. and Hewlett-Packard , increased in value to over $ 100,000 in price. Procter & Gamble in particular dropped nearly 37% before rebounding, within minutes, back to near its original levels. Stocks continued to rebound in

8550-460: The market bottom that was established at 13:45:28. During that period, the participant hedging its portfolio represented less than 5% of the total volume of sales in the market. David Leinweber, director of the Center for Innovative Financial Technology at Lawrence Berkeley National Laboratory , was invited by The Journal of Portfolio Management to write an editorial, in which he openly criticized

8664-639: The market would fall" were "replaced or modified 19,000 times" before they were canceled. Spoofing , layering , and front running are now banned. The Commodity Futures Trading Commission (CFTC) investigation concluded that Sarao "was at least significantly responsible for the order imbalances" in the derivatives market which affected stock markets and exacerbated the flash crash. Sarao began his alleged market manipulation in 2009 with commercially available trading software whose code he modified "so he could rapidly place and cancel orders automatically". Traders Magazine journalist, John Bates, argued that blaming

8778-493: The market, then big "buy" or "sell" orders could have led to sudden, big swings. It would have increased the probability of surprise distortions, as in the equity markets, according to a professional investor. In February 2011, the sugar market took a dive of 6% in just one second. On March 1, 2011, cocoa futures prices dropped 13% in less than a minute on the Intercontinental Exchange . Cocoa plunged $ 450 to

8892-609: The measures were to curb excessive speculation and potential share price manipulation . Two short-lived (less than a second) movements (more than 1%) in several (40 and 88) stock prices followed by recovery were reported for November 25, 2014. Events described as flash crashes typically exhibit a rapid partial or total price rebound. Conversely, rapid price falls in response to adverse news (e.g. disappointing earnings announcements) which do not rapidly revert are simply crashes or, colloquially, falling knives. 2010 flash crash The May 6, 2010, flash crash , also known as

9006-426: The most turbulent periods in the history of financial markets. New regulations put in place following the 2010 flash crash proved to be inadequate to protect investors in the August 24, 2015, flash crash — "when the price of many ETFs appeared to come unhinged from their underlying value" — and ETFs were subsequently put under greater scrutiny by regulators and investors. On April 21, 2015, nearly five years after

9120-442: The mutual fund. The Wall Street Journal quoted the joint report, "'HFTs [then] began to quickly buy and then resell contracts to each other—generating a ' hot-potato ' volume effect as the same positions were passed rapidly back and forth.'" The combined sales by the large seller and high-frequency firms quickly drove "the E-Mini price down 3% in just four minutes". From the SEC/CFTC report: The combined selling pressure from

9234-781: The new issue pipeline for CDOs slowed significantly, and what CDO issuance there was usually in the form of collateralized loan obligations backed by middle-market or leveraged bank loans, rather than home mortgage ABS. The CDO collapse hurt mortgage credit available to homeowners since the bigger MBS market depended on CDO purchases of mezzanine tranches. While non-prime mortgage defaults affected all securities backed by mortgages, CDOs were especially hard hit. More than half—$ 300 billion worth—of tranches issued in 2005, 2006, and 2007 rated most safe (triple-A) by rating agencies, were either downgraded to junk status or lost principal by 2009. In comparison, only small fractions of triple-A tranches of Alt-A or subprime mortgage-backed securities suffered

9348-657: The new rules should help provide certainty in advance as to which trades will be broken, and allow market participants to better manage their risks. In a 2011 article that appeared on the Wall Street Journal on the eve of the anniversary of the 2010 "flash crash", it was reported that high-frequency traders were then less active in the stock market. Another article in the journal said trades by high-frequency traders had decreased to 53% of stock-market trading volume, from 61% in 2009. Former Delaware senator Edward E. Kaufman and Michigan senator Carl Levin published

9462-639: The next few minutes, but ended down on the day's trading, most likely due to market concerns about the impact of a " hard Brexit "—a more complete break with the European Union following Britain's 'Leave' referendum vote in June . It was initially speculated that the flash crash may have been due to a fat-finger trader error or an algorithm reacting to negative news articles about the British Government 's European policy. On January 2, 2019,

9576-451: The opening) up to that point, plunging 998.5 points (about 9%), most within minutes, only to recover a large part of the loss. It was also the second-largest intraday point swing (difference between intraday high and intraday low) up to that point, at 1,010.14 points. The prices of stocks, stock index futures, options and exchange-traded funds (ETFs) were volatile, thus trading volume spiked. A CFTC 2014 report described it as one of

9690-408: The orders, as well as the manner in which they were entered, were both legitimate and consistent with market practices. These hedging orders were entered in relatively small quantities and in a manner designed to dynamically adapt to market liquidity by participating in a target percentage of 9% of the volume executed in the market. As a result of the significant volumes traded in the market, the hedge

9804-401: The period of the crash. Others speculate that an intermarket sweep order may have played a role in triggering the crash. Several plausible theories were put forward to explain the plunge. On September 30, 2010, after almost five months of investigations led by Gregg E. Berman, the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) issued

9918-417: The pooling and tranching activities on every level of the derivation. Others pointed out the risk of undoing the connection between borrowers and lenders—removing the lender's incentive to only pick borrowers who were creditworthy—inherent in all securitization. According to economist Mark Zandi : "As shaky mortgages were combined, diluting any problems into a larger pool, the incentive for responsibility

10032-438: The practice of displaying stub quotes that are never intended to be executed. Officials announced that new trading curbs , also known as circuit breakers , would be tested during a six-month trial period ending on December 10, 2010. These circuit breakers would halt trading for five minutes on any S&P 500 stock that rises or falls more than 10 percent in a five-minute period. The circuit breakers would only be installed to

10146-436: The public markets—a flood of unusual selling pressure that sucked up more dwindling liquidity". While some firms exited the market, firms that remained in the market exacerbated price declines because they "'escalated their aggressive selling' during the downdraft". High-frequency firms during the crisis, like other firms, were net sellers, contributing to the crash. The joint report continued: "At 2:45:28 p.m., trading on

10260-401: The ratings agencies were chronically behind on developments in the financial markets and they could barely keep up with the new instruments springing from the brains of Wall Street's rocket scientists. Fitch, Moody's, and S&P paid their analysts far less than the big brokerage firms did and, not surprisingly wound up employing people who were often looking to befriend, accommodate, and impress

10374-588: The safest/most senior tranches receiving the lowest rates and the lowest tranches receiving the highest rates to compensate for higher default risk . As an example, a CDO might issue the following tranches in order of safeness: Senior AAA (sometimes known as "super senior"); Junior AAA; AA; A; BBB; Residual. Separate special purpose entities —rather than the parent investment bank —issue the CDOs and pay interest to investors. As CDOs developed, some sponsors repackaged tranches into yet another iteration, known as " CDO-Squared ", "CDOs of CDOs" or " synthetic CDOs ". In

10488-551: The same fate. (See the Impaired Securities chart.) Collateralized debt obligations also made up over half ($ 542 billion) of the nearly trillion dollars in losses suffered by financial institutions from 2007 to early 2009. Prior to the crisis, a few academics, analysts and investors such as Warren Buffett (who famously disparaged CDOs and other derivatives as "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal" ), and

10602-455: The same financial events. They were strongly criticized by economist Joseph Stiglitz , among others. Stiglitz considered the agencies "one of the key culprits" of the crisis that "performed that alchemy that converted the securities from F-rated to A-rated. The banks could not have done what they did without the complicity of the ratings agencies." According to Morgenson, the agencies had pretended to transform "dross into gold." "As usual,

10716-433: The securities had difficulty selling the more lower level/lower-rated "mezzanine" tranches—the tranches rated somewhere from AA to BB. Because most traditional mortgage investors are risk-averse, either because of the restrictions of their investment charters or business practices, they are interested in buying the higher-rated segments of the loan stack; as a result, those slices are easiest to sell. The more challenging task

10830-468: The sell algorithm, HFTs, and other traders drove the price of the E-Mini S&;P 500 down approximately 3% in just four minutes from the beginning of 2:41 p.m. through the end of 2:44 p.m. During this same time cross-market arbitrageurs who did buy the E-Mini S&P 500, simultaneously sold equivalent amounts in the equities markets, driving the price of SPY (an exchange-traded fund which represents

10944-501: The start of the crash was "topped on 26 (49) preceding days, or 4.3% (8.1%) of the pre-crash sample". Note that the source of increasing "order flow toxicity" on May 6, 2010, is not determined in Easley, Lopez de Prado, and O'Hara's 2011 publication. Whether a dominant source of toxic order flow on May 6, 2010, was from firms representing public investors or whether a dominant source was intermediary or other proprietary traders could have

11058-554: The stock market shut down as they detected the sharp rise in buying and selling". As computerized high-frequency traders exited the stock market, the resulting lack of liquidity "caused shares of some prominent companies like Procter & Gamble and Accenture to trade down as low as a penny or as high as $ 100,000". These extreme prices also resulted from "market internalizers", firms that usually trade with customer orders from their own inventory instead of sending those orders to exchanges, "routing 'most, if not all,' retail orders to

11172-473: The supply of mortgages originated at traditional lending standards had been exhausted. The head of banking supervision and regulation at the Federal Reserve, Patrick Parkinson, termed "the whole concept of ABS CDOs", an "abomination". In December 2007, journalists Carrick Mollenkamp and Serena Ng wrote of a CDO called Norma created by Merrill Lynch at the behest of Illinois hedge fund, Magnetar. It

11286-437: The time of issue and earns management fees during the life of the CDO. The ability to earn substantial fees from originating CDOs, coupled with the absence of any residual liability, skews the incentives of originators in favor of loan volume rather than loan quality. In some cases, the assets held by one CDO consisted entirely of equity layer tranches issued by other CDOs. This explains why some CDOs became entirely worthless, as

11400-450: The total trading volume, while buying only about 200 additional contracts net. As prices in the futures market fell, there was a spillover into the equities markets. The computer systems used by most high-frequency trading firms to keep track of market activity decided to pause trading, and those firms then scaled back their trading or withdrew from the markets altogether. The New York Times then noted, "Automatic computerized traders on

11514-455: The total volume in the futures markets, which included currencies and commodities, an increase from 22% in 2009. However, the growth of computerized and high-frequency trading in commodities and currencies coincided with a series of "flash crashes" in those markets. The role of human market makers, who match buyers and sellers and provide liquidity to the market, was more and more played by computer programs. If those program traders pulled back from

11628-451: The trading volume calculated over the previous minute, but without regard to price or time". As the large seller's trades were executed in the futures market, buyers included high-frequency trading firms—trading firms that specialize in high-speed trading and rarely hold on to any given position for very long—and within minutes these high-frequency trading firms started trying to sell the long futures contracts they had just picked up from

11742-792: The traditional definition of market making. Specifically, High Frequency Traders aggressively trade in the direction of price changes. This activity comprises a large percentage of total trading volume, but does not result in a significant accumulation of inventory. As a result, whether under normal market conditions or during periods of high volatility, High Frequency Traders are not willing to accumulate large positions or absorb large losses. Moreover, their contribution to higher trading volumes may be mistaken for liquidity by Fundamental Traders. Finally, when rebalancing their positions, High Frequency Traders may compete for liquidity and amplify price volatility. Consequently, we believe, that irrespective of technology, markets can become fragile when imbalances arise as

11856-522: The tranches (70 to 80% ) of the CDO were rated not BBB, A−, etc., but triple A. The minority of the tranches that were mezzanine were often bought up by other CDOs, concentrating the lower rated tranches still further. (See the chart on "The Theory of How the Financial System Created AAA-rated Assets out of Subprime Mortgages".) As journalist Gretchen Morgenson put it, CDOs became "the perfect dumping ground for

11970-529: The transformation of BBB tranches into 80% triple A CDOs as "dishonest", "artificial" and the result of "fat fees" paid to rating agencies by Goldman Sachs and other Wall Street firms. However, if the collateral had been sufficient, those ratings would have been correct, according to the FDIC. Synthetic CDOs were criticized in particular, because of the difficulties to judge (and price) the risk inherent in that kind of securities correctly. That adverse effect roots in

12084-434: Was a selling point, as it meant that if there was a downturn in one industry like aircraft manufacturing and their loans defaulted, other industries like manufactured housing might be unaffected. Another selling point was that CDOs offered returns that were sometimes 2-3 percentage points higher than corporate bonds with the same credit rating. In 2005, as the CDO market continued to grow, subprime mortgages began to replace

12198-492: Was a tailor-made bet on subprime mortgages that went "too far." Janet Tavakoli, a Chicago consultant who specializes in CDOs, said Norma "is a tangled hairball of risk." When it came to market in March 2007, "any savvy investor would have thrown this...in the trash bin." According to journalists Bethany McLean and Joe Nocera, no securities became "more pervasive – or [did] more damage than collateralized debt obligations" to create

12312-483: Was arrested for his alleged role in the flash crash. According to criminal charges brought by the United States Department of Justice , Sarao allegedly used an automated program to generate large sell orders, pushing down prices, which he then canceled to buy at the lower market prices. The Commodity Futures Trading Commission filed civil charges against Sarao. In August 2015, Sarao was released on

12426-422: Was completed in approximately twenty minutes, with more than half of the participant's volume executed as the market rallied—not as the market declined. Additionally, the aggregate size of this participant's orders was not known to other market participants. Additionally, the most precipitous period of market decline in the E-Mini S&P 500 futures on May 6 occurred during the 3½ minute period immediately preceding

12540-547: Was designed to give investors the best possible price when dealing in stocks, even if that price was not on the exchange that received the order. At first, while the regulatory agencies and the United States Congress announced investigations into the crash, no specific reason for the 600-point plunge was identified. Investigators focused on a number of possible causes, including a confluence of computer-automated trades, or possibly an error by human traders. By

12654-490: Was released on bail, banned from trading and placed under the care of his father. Sarao pleaded guilty to one count of electronic fraud and one count of spoofing. In January 2020, he was given a sentence of one year's home confinement , with no jail time. The sentence was relatively lenient, as a result of prosecutors' emphasis on how much Sarao had cooperated with them, that he was not motivated by greed and his diagnosis of Asperger syndrome . A stock market anomaly ,

12768-610: Was then sold separately to different investors. Many of these tranches were in turn bundled together, earning them the name CDO (Collateralized debt obligation). The first CDOs to be issued by a private bank were seen in 1987 by the bankers at the now-defunct Drexel Burnham Lambert Inc. for the also now-defunct Imperial Savings Association. During the 1990s the collateral of CDOs was generally corporate and emerging market bonds and bank loans. After 1998 "multi-sector" CDOs were developed by Prudential Securities, but CDOs remained fairly obscure until after 2000. In 2002 and 2003 CDOs had

12882-466: Was triggered by a multimillion-dollar selling order which brought the price down, from $ 317.81 to $ 224.48, and caused the following flood of 800 stop-loss and margin funding liquidation orders, crashing the market. On October 7, 2016, there was a flash crash in the value of sterling , which dropped more than 6% in two minutes against the US dollar. It was the pound's lowest level against the dollar since May 1985. The pound recovered much of its value in

12996-488: Was undermined." Zandi and others also criticized lack of regulation. "Finance companies weren't subject to the same regulatory oversight as banks. Taxpayers weren't on the hook if they went belly up [pre-crisis], only their shareholders and other creditors were. Finance companies thus had little to discourage them from growing as aggressively as possible, even if that meant lowering or winking at traditional lending standards." CDOs vary in structure and underlying assets, but

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