Preliminary Findings Regarding the Market Events of May 6, 2010

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.

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.

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 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 were triggered by “fat finger” errors, computer hacking, or terrorist activity, although we cannot completely rule out these possibilities.

Key Avenues for Further Investigation

Much work is needed to determine all of the causes of the market disruption on May 6. At this stage, however, there are a number of key themes that we are investigating.

Futures and Cash Market Linkages. The first relates to the linkages between trading in equity index products, including stock index futures and the equity markets. About 250 executing firms processed transactions for thousands of accounts during the hour 2:00 p.m. – 3:00 p.m. in the E-Mini S&P 500 futures contract. Of these accounts, CFTC staff has more closely focused their examination to date on the top ten largest longs and top ten shorts. The vast majority of these traders traded on both sides of the market, meaning they both bought and sold during that period. One of these accounts was using the E-Mini S&P 500 contract to hedge and only entered orders to sell. That trader entered the market at around 2:32 and finished trading by around 2:51. The trader had a short futures position that represented on average nine percent of the volume traded during that period. The trader sold on the way down and continued to do so even as the price level recovered. This trader and others have executed hedging strategies of similarsize previously.3

Data from the CME order book indicates that, although trading volume in E-mini S&P 500 futures was very high on May 6, there were many more sell orders than there were buy orders from 2:30 p.m. to 2:45 p.m. The data also indicate that the bid ask spread widened significantly at or about 2:45 p.m. and that certain active traders partially withdrew from the market. Considerable selling pressure at this vulnerable period in time may have contributed to declining prices in the E-Mini S&P 500 – and other equivalent products such as the SPY (an ETF that tracks the S&P 500).

All of these markets are closely linked by a complex web of traders and trading strategies. The precipitous decline in price in one market on May 6 may have influenced a sustained series of selling in other financial markets. The rapid rebound in price in one market could similarly have been linked to a rebound in price in another.

Implications for the Equity Markets. The great majority of securities experienced declines that are generally consistent with the decline in value of the large indexes. Some were less than the approximately 5% decline in the E-mini S&P 500 during that period, and some were greater. Approximately 86% of securities, however, reached lows for the day that were less than 10% away from the 2:40 p.m. price.

The other 14% of securities suffered greater declines than the broader market, with some trading all the way down to one penny. The experience of these securities exposed potential weaknesses in the structure of the securities markets that must be addressed.

One hypothesis as to why the prices of some securities declined by abnormally large amounts on May 6 is that they were affected by disparate practices among securities exchanges. In the U.S. securities market structure, many different trading venues, including multiple exchanges, alternative trading systems and broker-dealers all trade the same stocks simultaneously. Disparate practices potentially could have hampered linkages among these trading venues and led to fragmented trading in some securities.

Two types of disparate practices on May 6 relate to the NYSE’s liquidity replenishment points (“LRPs”) and the self-help remedy in Regulation NMS. These and other practices merit significant ongoing review:

● LRPs and Similar Practices. The NYSE’s trading system incorporates LRPs that are intended to dampen volatility. When an LRP is triggered, trading on the NYSE will “go slow” and pause for a time to allow additional liquidity to enter the market. Some have suggested that LRPs actually exacerbated, rather than dampened, price volatility on May 6 by causing a net loss of liquidity, as orders were routed to other trading venues for immediate execution rather than waiting on the LRP mechanism. If this occurred, it potentially could have caused some NYSE securities to decline further than the broad market decline. However, others believe that the LRP mechanism indeed dampened volatility by rebuilding additional buy side liquidity that soaked up some of the excess selling interest in these securities on May 6. LRPs and other types of exchange procedures for handling or executing orders will be closely examined to determine whether they inappropriately impede liquidity.

● Self-Help Remedy. Another disparate exchange practice potentially relevant to the thinning of liquidity is the self-help remedy. Two exchanges declared self-help against NYSE Arca in the minutes prior to 2:40 p.m. Exchanges are entitled to exercise the self-help remedy when another exchange repeatedly fails to provide a response to incoming orders within one second. A declaration of self-help frees the declaring exchanges from their obligation to route orders to the affected exchange. Some have suggested the exercise of self-help led to a net loss of liquidity as the declaring exchanges stopped routing orders to NYSE Arca.

● Stop Loss Market Orders. An additional hypothesis as to why some securities suffered more severe declines than the broader market on May 6 is that they were particularly affected by stop loss market orders. These orders have stop prices that, for sell orders, are lower than current prices. When the stop price is reached, such orders turn into market orders to sell. In fast-falling market conditions, stop loss market orders could potentially trigger a chain reaction of automated selling if they are in place in significant quantity for a particular stock. We are investigating whether such a chain reaction led to abnormally large declines for some stocks on May 6.

• Short Sales and Stub Quotes. We also are examining the use of short sales and stub quotes on May 6. Our analysis thus far of broken trades has found that short sales accounted for approximately 70 % of executions against stub quotes between 2:45 p.m. and 2:50 p.m., and approximately 90 % of executions against stub quotes between 2:50 p.m. and 2:55 p.m. Notably, short sale executions against stub quotes would be subject to the alternative uptick rule (Rule 201) adopted by the SEC in February 2010, with a compliance date in November 2010.

In addition, we will evaluate the use of stub quotes by market makers. As noted above, stub quotes are not intended to be executed and effectively indicate that the market maker has pulled out of the market. Their presence at the bottom and top of order books on May 6 may have led to a very large number of broken trades. We will examine the extent to which market makers used stub quotes to nominally meet their market making obligations on May 6.

Exchange-Traded Funds. Of the U.S.-listed securities with declines of 60% or more away from the 2:40 p.m. transaction prices, which resulted in their trades being cancelled by the exchanges, approximately 70% were ETFs. This suggests that ETFs as a class were affected more than any other category of securities.

Based on our analysis to date, we are focused on a number of issues that may have contributed to the ETFs’ experience, including:

• Because ETFs generally track securities market indices, the extraordinary price declines in certain individual securities likely contributed to the ETF price declines. For the most part, the severe ETF price declines followed, in time, the sharp decline in the broad markets. ETFs that track bond indices generally did not experience severe price declines. We therefore are considering the linkages between ETF price declines and the declines in the equity market.

• The role of market makers and authorized participants in ETFs, and whether an inability to hedge their ETF positions during periods of severe volatility may have contributed to a lack of liquidity in ETF shares.

• The use of ETFs by institutional investors as a way to quickly acquire (or eliminate) broad market exposures and whether this investment strategy led to substantial selling pressure on ETFs as the market began to decline significantly.

• The impact of ETF stop loss market orders, particularly from retail investors, on the overall ETF market price declines.

• Given that NYSE Arca is the primary listing exchange for almost all ETFs, whether the declaration of “self-help” against NYSE Arca by other exchanges may have impacted NYSE Arca-listed stocks generally and ETFs in particular. The loss of access to NYSE Arca’s liquidity pool may have had a greater impact on market liquidity and trading for ETFs.

FUTURES MARKETS

Preliminary Findings

Economic evidence from the futures markets is also consistent with the conclusion that a liquidity drain likely played a role in the dramatic and sudden movements in the price of stock index futures.

As noted above, preliminary data indicates that, although trading volume in Emini S&P 500 futures was very high on May 6, there were many more sell orders than there were buy orders from 2:30 p.m. to 2:45 p.m. The data also indicate that the bid ask spread widened significantly at or about 2:45 p.m. and that certain active traders partially withdrew from the market.

Starting at 2:45:28 p.m., CME’s Globex stop logic functionality initiated a brief pause in trading in the E-mini S&P 500 futures. This functionality is initiated when the last transaction price would have triggered a series of stop loss orders that, if executed, would have resulted in a cascade in prices outside a predetermined ‘no bust’ range (6 points in either direction in the case of the E-mini). The purpose of this functionality is to prevent sudden, cascading declines (or increases) in price caused by order book imbalances.

The stop logic functionality has been activated previously for a variety of instruments. In the case of the E-mini S&P 500 futures, the stop logic functionality has been triggered a number of times in the past few years, including several times during the financial crisis in the Fall of 2008, when market data indicates similar conditions as those seen on May 6.

On May 6, activation of the stop logic functionality initiated a five second pause in trading on the E-mini S&P 500 futures contract. The price of the E-mini S&P 500 futures rebounded after the five second pause imposed by the stop logic functionality.

Staff analysis of market performance measures is consistent with the conclusion that a very temporary, but serious liquidity shortage occurred across the securities and futures markets.

NEXT STEPS

Securities Markets

SEC staff will continue our ongoing investigation of the nature of the overall market liquidity dislocation and the impact on individual stocks. Where appropriate we are moving quickly to prevent a recurrence of the harm that investors suffered on May 6.

• We anticipate that the self-regulatory organizations (exchanges and FINRA) will propose circuit breakers for individual stocks that are designed to address temporary liquidity dislocation. Specifically, a pause in trading should provide an opportunity for all available sources of liquidity (both manual and automated) to be mobilized to meet sudden surges in demand for liquidity.

• The procedures for breaking trades that occur at off-market prices should be improved to provide investors greater consistency, transparency and predictability.

• We are also continuing to review a range of other policy options, including addressing the use of stub quotes, reviewing the obligations of professional liquidity providers and evaluating the use of various order types (market orders, stop loss orders).

Futures Markets

CFTC staff will continue its analysis into the events of May 6. Specifically, CFTC staff is carefully reviewing the activity of the largest traders in stock index futures.

CFTC staff will also continue its analysis, already begun by our Office of Chief Economist, of liquidity provision in futures markets, with a particular focus on electronic trading. The subjects to be reviewed here include high frequency and algorithmic trading, automatic execution innovations on trading platforms, market access issues, and co-location.

CFTC staff is considering a proposed rulemaking with respect to exchange collocation and proximity hosting services. The purpose of the proposed rule would be to ensure that all otherwise qualified and eligible market participants that seek co-location or proximity hosting services offered by futures exchanges have equal access to such services without barriers that exclude access, or that bar otherwise qualified third-party vendors from providing co-location and/or proximity hosting services. Another purpose of the proposal would be to ensure that futures exchanges that offer co-location or proximity hosting services disclose publically the latencies for each available connectivity option, so that participants can make informed decisions.

CFTC staff will also be considering possible rules to enhance the CFTC’s surveillance capabilities. These measures include automation of the statement of reporting traders in the large trader reporting system and obtaining account ownership and control information in the exchange trade registers.4 These initiatives would increase the timeliness and efficiency of account identification, an essential step in data analysis.

Joint Actions

• Staff also intends to pursue a joint study to examine the linkages between correlated assets in the equities (single stocks, mutual funds and ETFs), options and futures markets. The study could partly focus on examining cross-market linkages by analyzing trading in stock index products such as equity index futures, ETFs, equity index options, and equity index OTC derivatives using, to the extent practicable, market data, special call information, and order book data.

• Existing cross-market circuit breaker provisions should be re-examined to ensure they continue to be effective in today’s fast paced electronic trading environment. Although the coordinated circuit breakers between futures and equities were not triggered, the events of May 6 reinforce the importance of having communication links between futures and equity markets so that there is meaningful and appropriate coordination of trading pauses and halts.

PROCESS OF ANALYSIS

Over the last ten days, the SEC and the CFTC have collected and analyzed a wide range of data from many different sources in order to prepare this preliminary report.

Specifically:

• The SEC has sourced and analyzed price, time, and volume data on over 19 billion shares executed on May 6, and quote data representing the best bid and best offer for over 7,800 securities, for each exchange, for each millisecond during the trading day. Our goal is to gather data necessary to create a complete order book showing snap-shots of the full displayable depth on a particular market and audit trail data containing detailed information on all orders submitted.

o Analysis of the complete order book is necessary to examine how changes in the provision of liquidity below the best bid, and above the best offer, led to rapid changes in execution prices, with some trades hitting high and low “stub quotes.”

o Analysis of order audit trail data is necessary to examine what types of orders were driving these price swings (e.g., market, limit, etc).

o The audit trail contains information on introducing brokers but does not include details regarding the trading activity of specific market participants. Currently, such data is only available directly from brokerdealers through “blue sheet” requests. Furthermore, even in this data participants are identified only in the way that they are known to the broker-dealer, as there are currently no uniform standards5

o The order book and order audit trail are maintained at exchanges, FINRA, broker-dealers and other market centers. In some cases this information must be collected by the SROs, and then must be compiled and organized by the SEC. Every exchange has established its own requirements for what constitutes an audit trail, including what items are captured, how

they are named, and the structure of the data file.

• The SEC has sourced and analyzed aggregate data on the volume and type of liquidity, provided and taken, by the largest liquidity providers and takers on various exchanges.

• The SEC has worked extensively with the relevant securities exchanges and FINRA to assess the circumstances of the market events on May 6. In addition, the SEC is analyzing detailed data for all NYSE LRPs occurring on May 6th, as well as over the last 5 months.

• CFTC staff has analyzed transaction and order book data on stock index futures, including the E-Mini S&P 500 futures contract.

• CFTC staff has been reviewing information from a special call on over 40 large traders for their trading activity in the E-mini S&P 500 and Russell 2000 futures contracts on May 6, 2010. A special call is a CFTC directive to a trader holding a reportable position to furnish any pertinent information concerning the trader’s positions, transactions, or activities.

• CFTC staff also has been reviewing information from a special call to swap dealers about their activity in over-the-counter broad-based security index derivatives markets on May 6, 2010. In addition, staff has been engaged in a detailed review of trader activity on May 6 through a comprehensive examination of trade-register data. To date, staff has received over 25 gigabytes of data in over 307,000 files, with more data expected.

Both the CFTC and the SEC have had extensive conversations with a wide variety of market participants (investors, hedge funds, exchange traded funds, dealers, high frequency traders, etc.) to better understand their trading activities throughout May 6, and to gather anecdotal evidence from which common themes and/or trends can be identified to inform further areas of investigation.

To read the full report, click here.

1 Joint Report of the SEC and the CFTC on Harmonization of Regulation, October 16, 2009.

2 All times in this report are EDT.

3 Statement of Gary Gensler, Chairman, Commodity Futures Trading Commission, Before the

House of Representatives Committee on Financial Services, Subcommittee on Capital Markets,

Insurance, and Government Sponsored Enterprises, May 11, 2010, at 8. Except as specifically

authorized, Section 8 of the Commodity Exchange Act generally forbids disclosure of additional information regarding such traders.

4 17 CFR 18.04.

5 For example, the same market participant may be known to different broker-dealers by different

names making the aggregation of orders for a single participant very difficult. For further details,

see the SEC’s recent proposal for the Large Trader Reporting System.