It has been one month since the market bottomed on Feb. 9. It was a wild week, one for the record books.
But the event most seared into trader’s minds was the 1,600 point swing in the Dow Jones industrial average on Feb. 5 (a 6 percent move), particularly the roughly 1,000 point drop in the late afternoon.
What happened, and does it warrant some kind of investigation?
After talking with several dozen market participants, there seems to be a broad consensus that a combination of factors caused the big drops:
1) The market was overpriced, primed for a correction.
2) Wage and inflation fears from the jobs report on Feb. 2 caused stocks to drop initially and bond yields to rise.
3) There was a very overcrowded trade — short volatility, long stocks — that was partially unwound on Feb. 5 and 6. The unwinding of the “short volatility” trade was expressed through many different trading strategies, including risk parity, momentum trading, shorting VIX futures, or by trading long and short VIX exchange-traded products.
One other point that was made by a number of traders was that liquidity dried up, that market makers reacted to the dramatically increased volatility by widening their quotes or simply canceling bids and offers.
Dave Lauer, who studies market structure and volatility, told me that this drying up was likely an exacerbating factor in the sell-off: “Posted liquidity disappeared as the price movement accelerated, and then it really didn’t come back until there were about 15 minutes left in trading.”
Market makers pulling back is no surprise. While they generally have an obligation to keep orderly markets, it doesn’t mean they have to step in front of a freight train.
How much was this a factor in the decline? Doug Cifu, CEO of Virtu, one of the largest market makers, noted that volumes increased dramatically on the afternoon of Feb. 5 and was sustained throughout the day. “There was not a liquidity problem. The market continued to trade,” he said in an email to me.
Other market participants also felt that market makers widened their quotes but that the impact was not nearly as great as the avalanche of selling: “There are no requirements you can put on market makers that would make a difference on a day like Feb. 5,” one market participant who asked to be anonymous told me. “When there is so much concentrated selling there is nothing that can stop that.”
Regardless of the cause, a bigger question remains: Does the notable size of the decline, and its suddeness, warrant an investigation?
When contacted by CNBC, representatives from the SEC and the Commodities Futures Trading Commission declined to comment whether there was any investigation into the trading activity on Feb. 5 and 6. That’s not surprising: they routinely refuse to confirm or deny investigations.
But should they be conducting an investigation?
Tyler Gellasch, CEO of Healthy Markets Association, an association of buy-side traders that look into market structure issues, believes they should be. He noted that after the May, 2010 Flash Crash, several reforms were implemented, including Limit Up-Limit Down rules that were designed to slow trading down during periods of exceptional volatility.
“I think it’s worth looking at the post-Flash Crash reforms and whether they were effective, and whether any of that should be tweaked. Are they calibrated to the right level? I also think we need to seriously look at what exactly the obligation of market makers are. Finally, it’s worth looking at whether we really need some of the volatility products that are being sold.”
One SEC commissioner — Kara Stein — already has expressed concerns about the need for leveraged and inverse exchange traded products, including volatility products, describing them as “quite the maze.”
“What troubles me is that oftentimes complex products fall into the hands of people who don’t fully understand them,” she said in a recent speech.
You can call all you want for an investigation, there’s one simple problem: Neither the SEC nor the CFTC has the complete tools to conduct an investigation. Previous studies of the Flash Crash in May 2010 did not come to a firm conclusion about the cause, nor did an investigation into a sudden crash in Treasurys in Oct., 2014.
Why the problem? Regulators do not have access to a complete record of all trading activity that would include who the participants are, as well as all information on canceled bids and offers. Without this, it’s impossible to put together a really detailed analysis of trading.
For several years, the SEC has been pushing the development of a Consolidated Audit Trail that would consolidate all this information in a single, massive data base, but so far it is mired in a debate about cost, who would have access to the information, and fears that the entire database could get hacked, giving thieves a treasure trove of information on how the entire Wall Street community trades stocks.
“It’s clear the regulators do not have as clear a view of the market as some of the market makers do,” Gellasch quipped.