Twice this month, dramatic movements emanating from electronic stock-index futures rippled through pit-traded futures -- and cash markets as well. The damage in both instances was limited and relatively brief.
But questions linger about these separate cases of the
of the tail wagging the proverbial dog and the possible effects of future episodes.
Because so much trading is computer generated -- program trading now regularly exceeds 40% of Big Board volume -- pessimists fret that future glitches in electronic futures could theoretically trigger a series of computer-generated sell orders. Those sales would send the market lower, trigger still more sell orders and devolve into a downward spiral.
Most observers dismiss such concerns, citing safeguards installed after the 1987 crash and the offsetting effects of multiple trading platforms.
participants in option markets, cash markets and futures markets all constantly arbitraging against each other," said Russell Wasendorf, chief operating officer at Peregrine Financial, a Chicago-based futures brokerage. "You aren't dealing with a situation where one market -- cash or futures -- can be controlled by any one force or an exchange glitch or someone attempting to manipulate the market."
Recent episodes suggest Wasendorf is correct. However, perhaps he should have added "for very long" to the end of that statement. Both incidents in electronic futures did cause dramatic, albeit short-lived, price movements in broader markets. Furthermore, some traders fret these relatively new vehicles provide opportunity for manipulation, because of the relatively small dollar amounts needed to move them.
The Chicago Board of Trade's mini-sized Dow futures are half the size of the standard Dow futures contract while the Chicago Mercantile Exchange's E-Mini S&P 500 futures are one-fifth the size of the pit-traded S&P futures. Because of their small size, the electronic futures have become very popular with investors looking for relatively inexpensive ways to bet on the indices or hedge other positions.
The episodes in question occurred on July 3 in the mini-size Dow futures, and on July 14 in the E-mini S&P futures.
During both sessions, major stock proxies suffered intraday setbacks amid rumors of erroneous trades. Market participants speculated that a gaffe occurred akin to
last October, when a Bear Stearns trader mistakenly placed an order to sell $4 billion worth of S&P securities vs. the intended $4 million sale.
In actuality, neither episode this month was the result of error.
The July 14 incident was caused by the "cascading effect" of a series of simultaneously executed stop orders, according to CME spokeswoman Maryellen Thielen. This created an order imbalance that caused the E-Mini S&P futures to fall from 1000 to 990.50 in four seconds.
"There were no errors," she declared. Still,
went awry that afternoon, as the Merc canceled, or "busted," E-mini trades below 996, as reported
The exchange plans to introduce "stops logic" technology this fall designed to "rectify price movements exacerbated by stop orders," Thielen said. She was unable to provide further detail.
In sum, the CME's July 14 episode seems to have been caused by an unfortunate confluence of events. Conversely, the July 3 incident involving the CBOT's mini-sized Dow futures appears the result of an intentional effort to unsettle the markets.
Mini Echo Boom, or Bust?
An order to sell 10,000 lots of mini-sized Dow futures was entered that day, a huge amount, considering the contract had average daily trading volume of about 48,000 contracts last month. (Reflecting the greater popularity of underlying S&P futures, E-mini S&P futures averaged about 600,000 contracts per day in June.)
Given thin volumes and an early close ahead of the July 4 holiday, the outsized sell order had an even greater impact. Electronic Dow futures tumbled nearly 600 points in short order. Foreshadowing the CME's July 14 decision, the CBOT later canceled all Dow futures trades below 9018. Still, the futures' swoon contributed to the
Dow Jones Industrial Average
falling more than 100 points from its intraday high and closing down 0.8%.
Monday morning, a CBOT spokeswoman said the incident is "currently being reviewed" but declined to comment further. Most market participants believe the trade was no accident.
"The CBOT made it clear you can't assume this was a fat-finger error, implying something done on purpose," said John Lothian, president of the electronic trading division of Price Futures Group in Chicago.
The episode demonstrated the potential for mischief, he continued. "If you know if you create an error in mini-Dow and it's going to be busted so you're not liable outside a certain range, and it's moving the other markets where those trades won't be busted," there's little disincentive for someone with nefarious intentions, Lothian said. (The episode also emboldened conspiracy theorists who believe the markets are increasingly manipulated via the futures, albeit usually to the upside.)
Of course, it's possible the 10,000-lot trade was placed in error and/or whoever was responsible will face stiff penalties, discouraging imitators.
Still, the July 3 incident was "the first big warning shot" about potential troubles emanating from the electronic futures, said Brad Sullivan, founder of Group 6 Trading, which specializes in index futures. "It showed you how many guys are involved in these program
trades" and employing strategies that "link all the futures together -- from mini Dow to Nasdaq and Russell and back." (The CME also offers E-mini products for the Nasdaq 100, Russell 2000 and S&P Mid-Cap 400.)
Sullivan further observed "a shift from the pit being the primary
futures market to electronic minis being primary," raising the possibility that future incidents in electronic futures could trigger massive dislocations, perhaps even a stock market crash.
"Yeah, it's possible," said Phil Flynn, senior market analyst with Alaron Trading, a Chicago-based futures and options brokerage. "It's very possible another 'mistake' could be made. As good as
electronic futures trading is, it's still in its infancy and we'll probably run across different problems as time goes by." Rather than precipitating a crash, however, Flynn wondered how electronic futures will fare in the event of one caused by other events.
To reiterate, most market participants don't worry about doomsday scenarios triggered by electronic futures.
"I don't see that happening," said Howard Simons, a special academic adviser at Nasdaq Liffe Markets and
contributor. "It would be a risk until a point where people understood there was a legit mistake, either malicious
or otherwise. Word gets out very quickly if there's an error in price and
the market would get back to where it was."
Nevertheless, Simons cautioned that "we all are susceptible" to dislocations in electronic futures, comparing the broader market to a highway, where "you're at the mercy of every other driver."
If stocks have an "accident," electronic futures will most certainly be involved. What role they'll play -- drunk driver or traffic cop -- remains to be seen.
Aaron L. Task writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks, although he owns stock in TheStreet.com. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to
Aaron L. Task.