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Flash Crash Rehashed -

Flash Crash Rehashed -

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CSFB's view of the flash crash and what effect expected regulations will have
CSFB's view of the flash crash and what effect expected regulations will have

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Published by: vagieray on May 19, 2010
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Portfolio Strategy

North America Market Commentary 19 May 2010

Ana Avramovic
+ 1 212 325 2438

AES® Analysis
The Flash Crash Rehashed
It All Started With…
Theories abound as to what caused the “Flash Crash” on May 6, 2010, when many stocks and ETFs experienced double-digit losses in a matter of minutes, then proceeded to rebound just as quickly. The SEC has yet to issue an official statement about what they believe was behind the sudden drop; on May 18 they issued a 151 page report that was inconclusive. They have formed a Joint CFTC-SEC Advisory Committee to investigate the events in a Senate hearing on May 20, 2010. While we don’t know what triggered the plunge, we do know the numbers when it was underway: In the S&P 500 alone, fully half of all stocks suffered an intraday loss of at least 10% 1 in 25 had a loss of more than 20% Nearly $700 bln of US market value was erased, before recovering Several stocks & ETFs posted prints around zero.
Exhibit 1: Distribution of intraday losses in the S&P 500
140 120 Number of stocks with given loss ... 100 80 60 40 20

Key points
In response to the May 6 “Flash Crash”, the exchanges & FINRA have announced new circuit breakers to prevent a repeat. We describe the new rule and analyze the potential impact such a circuit breaker would have had over the years. While we do not know exactly what caused the plunge, we present interesting facts that highlight the breadth and depth of stocks affected.

Exhibit 2: Breakdown by type of security in busted trades
Other 10%

0

Stocks 22%

-50%

-20%

-18%

-16%

-14%

-12%

-10%

-8%

-6%

-4%

-2%
®

0%

Intraday Loss

Source: Credit Suisse: AES Analysis

The Immediate Response: Canceled Trades
ETFs 68%

To address the extreme circumstances, the exchanges invoked their “Erroneous Trade” rule with modified terms. Any trades executed after 2:40pm where the print was at least 60% away from the NBBO were canceled. The rule impacted over 300 securities. Interestingly, the majority (68%) of the affected securities were ETFs. Furthermore, 10% were other types of securities such as closed-end funds and natural gas trusts (Ex 2). The fact that many ETFs disconnected from their NAV and sold off more than their underlying stocks suggests that ETF market makers simply withdrew.

**Other includes Closed-end funds; LP's and Unit Trusts
Source: Credit Suisse: AES® Analysis

AES®
The Standard in Algorithmic Trading

Portfolio Strategy New Exchange Circuit-Breaker Rule
When it kicks in: If a security moves by 10% within a 5 minute window What happens: Trading halted in the affected stock for 5 minutes, then re-opens for regular trading, still subject to another potential circuit breaker Securities affected: S&P 500 stocks only for an initial 6 mo. pilot period through Dec 10, 2010. May then add other stocks & ETFs Applicable hours: 9:45 am – 3:35 pm When Effective: The CB will be in place for a 6month pilot beginning in June. Could then potentially become permanent Next steps: There will be a 10 day comment period once the rule is published in the Federal Register

Don’t Blame the Short Sellers
In past market sell-offs, people have fingered short sellers for driving down prices. In fact, the SEC recently voted to re-instate a modified version of the uptick rule that would restrict short selling (for more on the rule, please refer to SEC Ups the Bid to Restrain Short Selling). The new rule will be fully effective by November 10, 2010. However, even if the limits were in place during the flash crash, only 38% of the S&P stocks would have been subject to short selling restrictions, because the threshold is measured relative to the previous day’s close, not the day’s high. But, as noted earlier, the cause of the drop was more likely due to a reduction in liquidity and a lack of bids from market-makers, rather than something like a short selling bear-raid.

Lasting Effects: Circuit Breakers
In response to widespread calls to institute a mechanism that would prevent a repeat crash, the exchanges have put forward a rule that would impose circuit breakers on individual securities (see box, left). The rule comes from the exchanges rather than the SEC in the interest of time, as an exchange directive can be in place more quickly than an emergency SEC order. Although some caution that officials should invest more time before altering market microstructure, in order to properly analyze potential consequences, others argue that prompt action is necessary to “restore market confidence.” The official SEC release also notes that they will consider further changes to existing market-wide circuit breakers (which did not trigger on May 6).

Exhibit 3: Average number of CB triggers per day
40 35 number of triggers in 1 day. 30 25 20 15 10 5 Sep-08 Sep-09 Jul-08 Jul-09 Jan-08 Jan-09 Nov-08 Nov-09 Jan-10 Mar-10 May-08 May-09 May-10 Mar-08 Mar-09

Potential Impact
We have conducted our own analysis of the impact a similar circuit breaker would have had since the beginning of 2008. For a circuit breaker in effect between 9:45am and 3:30pm that triggers when a stock in the S&P 500 declines by 10% within 5 minutes, we find that it would have gone into effect: Fewer than 10 times per day, on average, for every month except for the extraordinary period from September – November 2008. At the most extreme, in October 2008, it would have kicked in an average of around 40 times per day. On the other hand, over the entire period studied, from January 2008 – May 15, 2010, over half of all days would not have had any triggers at all. 80% of all days would have seen 3 or fewer triggers. It is important to keep in mind that this circuit breaker would not prevent large jumps at the beginning and end of the day. Also, large moves are common after certain news releases, especially M&A announcements or earnings. While these often occur outside of market hours, if they were to happen during the hours when a circuit breaker rule is in effect, the news would have a good chance of triggering the trading halt and potentially disrupting the natural price discovery process. Note on our calculations: in our study, we counted the number of times a stock declined by at least 10% in any non-overlapping 5 minute interval from 9:45am – 3:30pm. We did not count up moves, we did not use a rolling 5 minute window, and we did not consider any subsequent trading halt. 2

Source: Credit Suisse: AES Analysis
®

Exhibit 4: Distribution of daily circuit breaker triggers from Jan 2008-May2010
320 280 240 number of days 200 160 120 80 40 0

0

1

2

3

4

5

6

7

8

9

10

20 More

Number of times circuit breaker triggers in 1 day

Source: Credit Suisse: AES® Analysis

AES

®

The Standard in Algorithmic Trading

Portfolio Strategy

How to Find Our Reports Online: EDGE website
All AES Analysis and Portfolio & Derivatives Strategy reports are available on our website, Edge: http://www.credit-suisse.com/edge You can also reach EDGE from the CS Research & Analytics site, on the Equities tab, under Further Analysis > EDGE (on the right-hand sidebar)

Market Commentary Disclaimer
Please follow the attached hyperlink to an important disclosure: http://www.credit-suisse.com/legal_terms/market_commentary_disclaimer.shtml Structured securities, derivatives and options are complex instruments that are not suitable for every investor, may involve a high degree of risk, and may be appropriate investments only for sophisticated investors who are capable of understanding and assuming the risks involved. Supporting documentation for any claims, comparisons, recommendations, statistics or other technical data will be supplied upon request. Any trade information is preliminary and not intended as an official transaction confirmation. Use the following links to read the Options Clearing Corporation's disclosure document: http://www.cboe.com/LearnCenter/pdf/characteristicsandrisks.pdf Because of the importance of tax considerations to many option transactions, the investor considering options should consult with his/her tax advisor as to how taxes affect the outcome of contemplated options transactions. This material has been prepared by individual traders or sales personnel of Credit Suisse and its affiliates ('CS') and not by the CS research department. It is not investment research or a research recommendation, as it does not constitute substantive research or analysis. It is provided for informational purposes, is intended for your use only and does not constitute an invitation or offer to subscribe for or purchase any of the products or services mentioned. The information provided is not intended to provide a sufficient basis on which to make an investment decision. It is intended only to provide observations and views of individual traders or sales personnel, which may be different from, or inconsistent with, the observations and views of CS research department analysts, other CS traders or sales personnel, or the proprietary positions of CS. Observations and views expressed herein may be changed by the trader or sales personnel at any time without notice. Trade report information is preliminary and subject to our formal written confirmation. CS may, from time to time, participate or invest in transactions with issuers of securities that participate in the markets referred to herein, perform services for or solicit business from such issuers, and/or have a position or effect transactions in the securities or derivatives thereof. The most recent CS research on any company mentioned is at http://www.csfb.com/researchandanalytics. Backtested, hypothetical or simulated performance results have inherent limitations. Simulated results are achieved by the retroactive application of a backtested model itself designed with the benefit of hindsight. The backtesting of performance differs from the actual account performance because the investment strategy may be adjusted at any time, for any reason and can continue to be changed until desired or better performance results are achieved. Alternative modeling techniques or assumptions might produce significantly different results and prove to be more appropriate. Past hypothetical backtest results are neither an indicator nor a guarantee of future returns. Actual results will vary from the analysis. Past performance should not be taken as an indication or guarantee of future performance, and no representation or warranty, expressed or implied is made regarding future performance. The information set forth above has been obtained from or based upon sources believed by the trader or sales personnel to be reliable, but each of the trader or sales personnel and CS does not represent or warrant its accuracy or completeness and is not responsible for losses or damages arising out of errors, omissions or changes in market factors. This material does not purport to contain all of the information that an interested party may desire and, in fact, provides only a limited view of a particular market. © Copyright 2009 Credit Suisse Securities (USA) LLC, and its subsidiaries and affiliates (together "Credit Suisse"). All rights reserved. AES, Advanced Execution Services, INLINE and TWAP are registered trademarks of Credit Suisse. Various features of the Advanced Execution Services system are patent pending.

AES

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The Standard in Algorithmic Trading

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