U.S. Commodity Futures Trading U.S. Securities & Exchange Commission Commission 100 F Street, NE Three Lafayette Centre Washington, D.C. 20549 1155 21st Street, NW (202) 551-5500 Washington, D.C. 20581 www.sec.gov (202) 418-5000 www.cftc.gov Preliminary Findings Regarding the Market Events of May 6, 2010 Report of the Staffs of the CFTC and SEC to the Joint Advisory Committee on Emerging Regulatory Issues May 18, 2010 This is a report of preliminary findings by the staffs of the U.S. Commodity Futures Trading Commission and the U.S. Securities and Exchange Commission. The Commissions have expressed no view regarding the preliminary analysis or conclusions contained herein. Table of Contents I. INTRODUCTION .............................................................................................................1 II. EXECUTIVE SUMMARY ..............................................................................................2 III. GENERAL MARKET CONTEXT ............................................................................ 11 IV. PRELIMINARY FINDINGS ....................................................................................... 17 A. Securities Markets .............................................................................................. 17 1. Broader Market Drop and Recovery................................................................. 17 2. Securities that Suffered Declines Disproportionate to the Broader Market ..... 29 B. Futures Markets.................................................................................................. 59 1. Background....................................................................................................... 59 2. Role of Liquidity in Markets............................................................................. 63 3. Analysis of Large Traders................................................................................. 66 4. Preliminary Findings......................................................................................... 69 C. Clearance and Settlement................................................................................... 69 1. Securities Markets............................................................................................. 69 2. Futures Markets ................................................................................................ 70 V. NEXT STEPS................................................................................................................... 72 A. Areas for Further Analysis ................................................................................ 72 1. Securities Markets............................................................................................. 72 2. Futures Markets ................................................................................................ 74 3. Coordinated Analysis........................................................................................ 74 B. Potential Regulatory Responses......................................................................... 75 1. Securities Markets............................................................................................. 75 2. Futures Markets ................................................................................................ 79 APPENDIX A OVERVIEW OF THE SECURITIES MARKET STRUCTURE ...A­1 APPENDIX B OVERVIEW OF THE FUTURES MARKET STRUCTURE .........B­1 APPENDIX C CROSS-MARKET CIRCUIT BREAKERS.........................................C-1 APPENDIX D FUTURES MARKET INFORMATION...............................................D-1 i I. INTRODUCTION The Commodity Futures Trading Commission (“CFTC”) and the Securities and Exchange Commission (“SEC” and collectively, the “Commissions”) have established a Joint CFTC-SEC Advisory Committee on Emerging Regulatory Issues (the “Committee”). The establishment of the Committee was one of 20 recommendations included in the agencies’ joint harmonization report issued last year.1 The first item on the agenda of the Committee will be to conduct a review of the market events of May 6 and to make recommendations related to market structure and liquidity issues that may have contributed to the volatility experienced on that day, as well as disparate trading conventions and rules across various markets. This report to the Committee reflects the preliminary findings of the Commissions’ respective staffs resulting from their ongoing review of the events of May 6. The report is intended to brief the Committee regarding the May 6 events and to provide certain context regarding the current structure of the equity and futures markets and the regulatory framework for those markets. This report includes: (a) an executive summary; (b) an overview providing general market context with respect to the events of May 6; (c) preliminary findings with respect to those events; and (d) areas for further analysis and initial next steps. In addition, this report contains several appendices providing relevant background regarding the market structure of the securities and futures markets. It is important to emphasize that the review of the events of May 6 is in its preliminary stages and is ongoing. The reconstruction of even a few hours of trading during an extremely active trading day in markets as broad and complex as ours— involving thousands of products, millions of trades and hundreds of millions of data points—is an enormous undertaking. Although trading now occurs in microseconds, the framework and processes for creating, formatting, and collecting data across various types of market participants, products and trading venues is neither standardized nor fully automated. Once collected, this data must be carefully validated and analyzed. Such further data and analysis may substantially alter the preliminary findings presented in this report. The staffs of the Commissions therefore expect to supplement this report with further additional findings and analyses. 1 Joint Report of the SEC and the CFTC on Harmonization of Regulation, October 16, 2009. 1 II. EXECUTIVE SUMMARY On May 6, 2010, the financial markets experienced a brief but severe drop in prices, falling more than 5% in a matter of minutes, only to recover a short time later. Since that day, the staffs of the Securities and Exchange Commission and the Commodity Futures Trading Commission have been collecting and reviewing massive amounts of information in order to understand the events and to recommend appropriate measures. SECURITIES MARKETS Preliminary Findings May 6 started with unsettling political and economic news from overseas concerning the European debt crisis that led to growing uncertainty in the financial markets. Increased uncertainty during the day is corroborated by various market data: high volatility; a flight to quality among investors; and the increase in premiums for buying protection against default by the Greek government. This led to a significant, but not extraordinary, down day in early trading for the securities and futures markets. Beginning shortly after 2:30 p.m.,2 however, this overall decline in the financial markets suddenly accelerated. Within a matter of a few minutes, there was an additional decline of more than five percent in both the equity and futures markets. This rapid decline was followed by a similarly rapid recovery. This extreme volatility in the markets suggests the occurrence of a temporary breakdown in the supply of liquidity across the markets. The decline and rebound of prices in major market indexes and individual securities on May 6 was unprecedented in its speed and scope. The whipsawing prices resulted in investors selling at losses during the decline and undermined confidence in the markets. Although evidence concerning the behavior of the financial markets on May 6, 2010 continues to be collected and reviewed, a preliminary picture is beginning to emerge. At this point, we are focusing on the following working hypotheses and findings– (1) possible linkage between the precipitous decline in the prices of stock index products such as index ETFs and the E-mini S&P 500 futures, on the one hand, and simultaneous and subsequent waves of selling in individual securities, on the other, and the extent to which activity in one market may have led the others; (2) a generalized severe mismatch in liquidity, as evinced by sharply lower trading prices and possibly exacerbated by the withdrawal of liquidity by 2 All times in this report are EDT. 2 electronic market makers and the use of market orders, including automated stop-loss market orders designed to protect gains in recent market advances; (3) the extent to which the liquidity mismatch may have been exacerbated by disparate trading conventions among various exchanges, whereby trading was slowed in one venue, while continuing as normal in another; (4) the need to examine the use of “stub quotes”, which are designed to technically meet a requirement to provide a “two sided quote” but are at such low or high prices that they are not intended to be executed; (5) the use of market orders, stop loss market orders and stop loss limit orders that, when coupled with sharp declines in prices, for both equity and futures markets, might have contributed to market instability and a temporary breakdown in orderly trading; and (6) the impact on Exchange Traded Funds (ETFs), which suffered a disproportionate number of broken trades relative to other securities. We have found no evidence that these events