On Tuesday, the House Financial Services Committee will hold a hearing to find out what exactly happened on Thursday, May 6, to send the Dow Jones Industrial Average diving 1,000 points in a matter of minutes.
This is perhaps the first time that a congressional hearing will actually be useful in financial fact-finding. The truth of what happened is buried among records of billions of Thursday trades. The New York Stock Exchange and Nasdaq, unable to publicly explain the cause, chose a “kill them all and let God sort them out” approach, cancelling thousands of trades.
The days since the plunge have been plagued with conflicting news reports, widespread suspicion about the power of computers, allegations of cyberterrorism and other species of rampant theorizing—all great material for conspiracy theorists and fans of The Matrix, but not as great for people trying to piece together why, exactly, the markets spiraled out of control.
Here is The Big Money’s guide to the top five mysteries surrounding the market rout.
1. What caused it?
It is surprising that this should be the biggest mystery,considering that the New York Stock Exchange, Nasdaq, and the “dark pools” all run mostly on computers, which should make it easy to scan for an errant trade or evidence of a glitch. Almost everyone agrees that, at some point, computers programmed to trade at certain prices took over and magnified the problem. But what caused the problem? As a Wall Street Journal headline so eloquently put it, “regulators can’t name cause of market slide.”
So for the primary mover, we’re worse off than not knowing: We’re getting vastly conflicting accounts. The only real piece of information to come out from five days of investigations is this: It probably started with “aberrations” in Chicago. The Chicago Mercantile Exchange, however, is somehow positive it wasn’t a cyberattack.
Initially, rumors held that a trader (in Chicago, perhaps)
It’s also impossible to find out when exactly the crash started. The New York Times and WSJ go with 2:40 pm. CNBC calls it the “Crash of 2:45.” The Wall Street Journal’s Deal Journal pointed out that trading volume moved up at 2:30 p.m., and that the NYSE Arca tripped some switches at 2:37 p.m. Considering that there are hundreds of thousands of trades each minute, that seemingly small distinction is important.
2. Why has no one come forward to take responsibility?The problem with the “fat-finger trade” theory is this: No firm or person has claimed that the trade was theirs. In fact, several firms, including Citigroup (C) and Terra Nova Financial, issued categorical denials. Refusing to take responsibility is highly unusual behavior for trading firms: especially in a market crash, it looks particularly craven. To some, the blankness of the faces involved is a good argument for more regulation of “dark pools” that trade securities far away from the prying eyes of the exchanges. But this blankness is also the primary reason that some suspect either market manipulation or cyberattack.
3. Why did the exchanges cancel trades if they insist there was no glitch?
The New York Stock Exchange and Nasdaq both denied that there was any technological glitch in their trading, meaning that the bizarre trades were due to forces outside their control. The exchanges could be telling the absolute truth, or they could be avoiding some embarrassing assumptions people might make in light of past, similar technological problems. (Both exchanges have histories of pricing glitches and blackouts.) Nonetheless, both exchanges unilaterally decided that they would cancel all trades in stock whose prices changed more than 60 percent. This is the largest single cancellation of stock trades in history.
To traders, this makes no sense: If there were a provable glitch, the cancellations would be fine. But if there was no technical glitch and the system as a whole was just doing its job, then the exchanges interfered with bargain shopping.
The exchanges did a terrible job of communicating with those whose trades were cancelled. Alan Lancz, a newsletter author and adviser to high-net-worth individuals, told the Wall Street Journal that his traders were left high and dry, stuck with cancelled trades and absolutely no information from the exchanges. Similarly, the CEO of network software firm Opnet told CNN Money that he only found out from a news story that his company’s stock was included in the cancelled trades. Opnet’s worst trades were cancelled, but the company is still stuck with a misleading 52-week low, as are Procter & Gamble and Accenture, the stocks of which were infamously hit hard.
4. Why can’t the exchanges get their stories straight?
The New York Stock Exchange and Nasdaq are both losing market share to electronic exchanges and upstart competitors. They also compete intensely with each other, with a long history of smack-talking on the court. It’s probably no wonder, then, that the first reaction of each was to get into a hand-flapping tizzy blaming the other. The Nasdaq blamed the NYSE for walking away from stock trading. The NYSE blamed the Nasdaq and others for not jumping in when its own systems slowed down trading. The NYSE, resentful about the loss of many of its floor traders in the rush to technology, also used the excuse as occasion to settle some old scores, strangely insisting that the whole problem with all these computers is exactly why the NYSE needs to have floor traders. Perhaps true, but saying “we need humans because our computers don’t work” is hardly a confident defense. Besides, the humans didn’t too great a job of reining things in, either. And on Wednesday, well before the crash, the NYSE’s hand-held devices failed floor traders in a pretty big trading glitch.
5. What is the connection between the stocks that crashed?
There are almost no common characteristics among the biggest stock movers that day: Procter & Gamble is a consumer stock, Accenture (ACN) is a financial stock; Boston Beer Company (SAM) sells Sam Adams beer (its stock deserved to go up, anyway, because surely people were drinking more on Thursday). The “e-minis” theory partially explains these connections because it’s very possible for various unrelated stocks to appear in a single trading “basket”—but again, with no proof that e-minis were the problem, it’s hard to pin down a real reason.
In addition, it’s unclear why exchange-traded funds, or ETFs, made up the majority of the cancelled trades. ETFs accounted for 69 percent of all the trades that were cancelled, meaning that their prices swung more than 60 percent. That’s too high a number to be a coincidence, but why these funds? It might be because most ETFs are created to track particular indexes, such as the Dow Jones Industrial Average or S&P 500, which themselves experienced wild swings. But as usual on this subject, answers—not guesses—are in short supply.
Bonus question: Can this happen again?
We’re assuming it can. But it would be nice to know for sure.
If Tuesday’s congressional hearing can clarify even one or two of these issues, they will be a success. But, having conducted one too many political circuses on Lehman Bros., Bear Stearns, Goldman Sachs (GS), and TARP, it’s hard to believe the Hill will generate answers any time soon.
Heidi N. Moore, a financial journalist in New York City, is a former reporter for The Wall Street Journal. Her work has also appeared in New York, Institutional Investor and the Financial Times. She tweets here.