Thursday afternoon’s wild trading in U.S. stock markets will be the subject of analysis and recriminations for some time to come. On 6 May 2010, investors witnessed the sixth-largest daily share trading volume of all time in U.S. markets, as well as the single biggest ever intraday points drop for the Dow Jones Industrial Average. But what caused the “flash crash” (named after the “flash” or algorithmic trading programmes that have been blamed by some for exacerbating price moves) is still the topic of active debate.

Some point to a “fat-fingered” trader at one of the major banks as the primary culprit, others suggest that currency market volatility might have been the trigger, while concerns over European debt markets or a “series of high-volume trades in S&P futures contracts” are also cited as possible catalysts for the market drop.

According to Nizam Hamid, head of sales strategy at iShares in Europe, “a handful of large-cap stocks in the U.S. showed large price movements, which fed through to index calculations and index levels, and in turn to a snowballing effect, with bids being withdrawn and prices moving down to very low levels. But perhaps what happened on Thursday could be seen more fundamentally as symptomatic of a lack of demand for shares at current levels. It’s similar in a way to what happened in 1999/2000 during the internet bubble, when limited supply caused share prices to rocket – except that this time it’s in reverse.”

Although ETFs and ETNs were represented disproportionately amongst the securities with cancelled trades during Thursday’s trading on the NYSE and Nasdaq, it would be unfair to point the finger specifically at exchange-traded products, says Hamid.

“I don’t see what happened on Thursday as an ETF-specific problem. It was more a market maker or exchange pricing problem. The question is whether certain stocks or ETFs should have stopped trading for a while, given the demand-supply anomalies that took place. Currently in the U.S., if one market stops trading a stock or ETF you can just go off and carry on trading elsewhere, complicating things further as the algorithmic trading programmes just carry on looking for the next available bid if they want to sell. The fact that a lot of good-till-cancelled limit orders were left in the system also exacerbated things,” Hamid explained.

Competitive pressure in the trading community to execute trades at ever-faster speeds may have contributed to the instability, according to Bart Lijnse, managing director at market maker Nyenburgh. “In the U.S. the competition to trade at ever-faster speeds has become so fierce that some people have taken out all pre-trade risk checks. There’s a popular software package that takes around 168 microseconds (millionths of a second) to run such pre-trade risk checks. But the fastest trading firms can execute in a much faster 18 microseconds, so anyone using the risk checking software is put at a competitive disadvantage. In Europe most people still use such checks, but there is increasing pressure to abandon them for the same competitive reasons as we have seen in the US,” said Lijnse.

The surge in market volatility over the last two weeks is causing capacity problems of a different type. Monday’s announcement of a €700 billion rescue plan for beleaguered European sovereign debtors led to an enormous relief rally in equity and credit markets. But as a result, certain European exchanges, notably NYSE Euronext and Borsa Italiana, have had problems coping with greatly increased trading volumes, according to one ETF market maker. “The exchanges claim that they are able to provide fast trading access, but then they should show that they are able to cope with the resulting flows,” the market maker said.

Hamid of iShares points to a fundamental change in share trading mechanics as partly responsible for the surge in traffic being faced by the exchanges. “Four or five years ago, a €60 billion trading day would have been made up primarily of large institutional block trades. Now, with the take-off of DMA (direct market access) and algorithmic trading there is a huge number of much smaller trading lots, as orders are broken down into smaller components for execution on different platforms. The exchanges’ bandwidth has to be much higher than it was before. Trading has changed fundamentally, with much more fragmentation and less visibility. As an ETF provider, we want to see more transparency as client confidence is boosted when people can see more clearly what’s going on in the markets.”

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