Trading program sparked May 'flash crash'

NEW YORK (CNNMoney.com) -- A large investor using an automated trading software to sell futures contracts sparked the brief-but-historic stock market "flash crash" on May 6, according to a report by federal regulators released Friday.

In the 104-page report, staff members at Securities and Exchange Commission and the Commodity Futures Trading Commission said an unnamed investor used a trading algorithm to sell orders for futures contracts called E-Minis, which traders use to bet on the future performance of stocks in the S&P 500 index.

The contracts were sold quickly and in large numbers, according to the report, on a day when the market was already under stress due to concerns about the European debt crisis.

The selling was initially absorbed by "high frequency traders" and other buyers, the report said. But the algorithm responded to an rise in trading volume by increasing the number of E-Mini sell orders it was feeding into the market.

"What happened next is best described in terms of two liquidity crises -- one at the broad index level in the E-Mini, the other with respect to individual stocks," the report said.

In other words, the lack of buyers and the rapid selling of E-Mini futures contracts began to affect the underlying stocks and the broader stock indexes.

As a result, the Dow Jones industrial average plunged nearly 1,000 points, briefly erasing $1 trillion in market value, before regaining much of the lost ground to close lower. It was the largest one-day drop on record.

Waddell & Reed, an asset management and financial planning company based in Overland Park, Kan., has been widely reported as the investor behind the sell order. But the report identified only a "large fundamental investor."

Waddell said in May that it was one of possibly 250 other investors trading the E-mini futures contract on the day in question, and that it did not intend to disrupt the market.

The report outlined in detail the technical factors that gave rise to the market turmoil. But it did not contain any specific policy recommendations that would prevent another flash crash from happening, which caught some on Wall Street off gaurd.

"It's a good synopsis of what went on," said Joe Saluzzi of Themis Trading. "But there are no recommendations here."

The report has been submitted to a joint SEC-CFTC advisory committee, which will eventually make recommendations to Congress related to market structure issues and disparate trading rules across various markets.

SEC chairman Mary Schapiro and CFTC chairman Gary Gensler said in a joint statement that the report "reaffirms the importance of a number of the actions we have taken since that day."

"We now must consider what other investor-focused measures are needed to ensure that our markets are fair, efficient and resilient, now and for years to come," the statement said.

In June, the SEC approved new rules that will halt trading uniformly across all U.S. markets for stocks experiencing wild price swings.

The so-called circuit breakers require exchanges to stop trading in an individual stock for five minutes across U.S. stock markets if the stock experiences a 10% price swing in the preceding five-minute period.

Rep. Paul Kanjorski, D-Pa., who chairs a House subcommittee on capital markets, praised the report but said more needs to be done to rein in the use of algorithms used by high frequency traders.

"The SEC and CFTC report confirms that faster markets do not always lead to better markets," Kanjorski said in a statement. "While automated, high-frequency trading may provide our markets with some benefits, it can also carry the potential for serious harm and market mischief."