In the days leading up to the May 6 ‘flash crash,’ some stock-market veterans were picking up disturbing rumblings.

Philip Vasan, who heads the Credit Suisse prime-brokerage unit catering to hedge funds, began hearing from fund managers who were ratcheting back on trading because, they told him, stocks were behaving strangely. The funds were acting like ‘a dog that growls before an earthquake,’ Mr. Vasan told several clients.

When the quake hit on the afternoon of May 6, the Dow Jones Industrial Average suffered its biggest, fastest decline ever, and hundreds of stocks momentarily lost nearly all their value. So many things went wrong, so quickly, that regulators haven’t yet pieced together precisely what happened.

A close examination of the market’s rapid-fire unraveling reveals some new details about what unfolded: Stock-price data from the New York Stock Exchange’s electronic-trading arm, Arca, were so slow that at least three other exchanges simply cut it off from trading. Pricing information became so erratic that at one point shares of Apple Inc. traded at nearly $100,000 apiece. And computer-driven trading models used by many big investors, apparently responding to the same market signals, rushed for the exits at the same time.

Three months later, many market veterans have arrived at a disquieting conclusion: A flash crash could happen again because today’s computer-driven stock market is much more fragile than many believed. Many investors, still gun-shy, have been pulling money out of stocks.

‘The whole system failed,’ says John Bogle, founder of fund company Vanguard Group. ‘In an era of intense technology, bad things can happen so rapidly. Technology can accelerate things to the point that we lose control.’

9:30 a.m., Dow opens at 10862.22

Early trading was relatively smooth. Todd Sandoz, co-head of equities in the Americas at Credit Suisse in New York, kept track as clients reduced risk in their portfolios. One way they did it was through trades that would profit if the Standard & Poor’s 500-stock index fell: They sold short, or bet against, futures contracts linked to that index. They did the same with exchange-traded funds, which track baskets of stocks.

Those kinds of trades can send waves through the market. Brokers on the other side of the trades often hedge their own positions by selling the stocks contained in the index. That morning, Mr. Sandoz heard from his traders that there were relatively few buyers and sellers for some individual stocks — a sign that the market might not be able to smoothly handle big index trades.

The market was especially vulnerable because of the trading pullback identified by his colleague Mr. Vasan. The hedge funds that had been pulling back for several days — specialists in a strategy called statistical arbitrage — normally trade so much stock that they are a key source of market liquidity.

At about 2 p.m., as protests in Athens over the Greek debt crisis turned violent, the euro fell sharply, especially against the yen. The euro-yen exchange rate is watched widely by traders, with the yen seen as a safe-haven currency, the euro a proxy for riskier investments.

The euro’s fall triggered concerns that a rush out of stocks was in the works. At Chicago hedge fund Sharmac Capital Management LLC, trader Jason Roney noticed the drop. ‘Something is wrong, look out!’ he recalls shouting to his trading desk. He started shorting S&P 500 futures.

Traders across Wall Street were making similar moves, many driven by computer models that have become standard tools at banks, hedge funds and mutual funds.

Fund managers at Waddell & Reed Financial Inc. in Overland Park, Kan., moved to hedge their U.S. stock holdings, which total more than $7 billion, by betting that the S&P 500 would fall. Waddell decided on a large short sale of futures contracts known as E-minis, which mimic movement of the S&P 500. As Waddell’s computers began parceling out the trade, other investors also were trying to hedge their portfolios, so trading volume in E-minis shot up to six times the usual volume.

But liquidity, the ability to buy or sell easily, was drying up. Between about 2:35 and 2:45, the six ‘market-making’ firms that were most active that afternoon in E-mini trading — they step in as buyers or sellers on many trades — cut back their trading. Some pulled out altogether.

As a result, traders say, the big Waddell trade accelerated the sell-off. Waddell says it did not intend to ‘disrupt’ the market.

Computers started to groan under the weight of the orders and slow by fractions of a second. It became difficult for exchanges and investors to keep track of prices.

In recent years, due in part to rules instituted by the Securities and Exchange Commission in 2007, the stock market has been opened to numerous trading venues and has evolved into a high-speed network. The rules stipulate that when an investor trades a stock, the order is routed to the venue with the best price.

On the afternoon of May 6, it was difficult for traders to trust the information they were getting, and for buyers and sellers to find each other. Nasdaq OMX Group Inc. operations personnel noticed problems with orders it had routed to Arca, the electronic trading platform of the NYSE, which handles about 12% of U.S. stock-trading volume. It was taking Arca longer to acknowledge receiving some orders. Orders for Nasdaq-listed stocks such as Apple and Amazon.com Inc. were hitting lags of two seconds or more on Arca — an eternity in today’s markets.

Trading in Apple became especially volatile. At 2:40, its stock began falling swiftly, losing 16% in six minutes. Because Apple is a component of several indexes, weakness in the stock helped drag down the broader market.

Concerned about the impact of the delay on orders routed to Arca, Nasdaq officials used a tool called ‘self help,’ designed to prevent problems at one exchange from spreading to others. At 2:36:59, Nasdaq stopped routing orders to Arca. Other exchanges, including Chicago Board Options Exchange and BATS Global Markets, an electronic-exchange near Kansas City, Mo., did the same.

The NYSE says Arca had ‘minor delays’ on a computer server during the period, but says the problems were not significant and didn’t add to the market’s broader problems.

Computer systems at big brokerage firms were straining to keep up with the volume. Dark pools, trading venues that match buyers and sellers away from the major exchanges, had trouble getting accurate information. Some temporarily shut down.

2:40 p.m., Dow down 415 points

High-frequency-trading firms, which account for some two-thirds of U.S. stock-trading volume, were having their own problems. Their strategies often involve buying and selling stocks within microseconds — or one-millionth of a second. The market’s plunge, along with discrepancies in data feeds from exchanges, scrambled their computer-trading systems.

With the Dow industrials down about 500 points, Tradebot Systems Inc., a Kansas City high-speed trading firm that says it can account for up to 5% of daily volume, pulled out. Other such firms did the same.

The roar on the floor of the Chicago Mercantile Exchange was deafening as the sell-off accelerated. The E-mini contract suddenly fell a massive 12.75 points in half a second, triggering a CME circuit-breaker that stopped trading for five seconds. The pause gave computerized futures-trading systems time to stabilize.

On the floor of the NYSE, the fast declines in some stocks were triggering brief slowdowns in trading, known as ‘liquidity replenishment points,’ to allow floor traders to step in and restore order. Other exchanges, such as the Nasdaq, didn’t slow trading.

Among the problems this caused were ‘crossed’ markets, where offers to buy were at prices higher than orders to sell. Around 2:46, for example, an investor offered to buy Apple for about $218, while another was willing to sell it for about $202. Such nonsensical quotes sent warning signals to computer systems and gave traders yet another reason to pull back.

Stocks everywhere started to collapse. Apple lost more than $23 a share, or 10%, between 2:44 and 2:46. Procter & Gamble Co., which had been trading around $61.50, saw huge sell orders hit the NYSE, and the exchange briefly slowed trading in the stock. By 2:47, the market for P&G was in chaos, with orders to buy from NYSE, Nasdaq and the BATS scattered from $39.89 to $44.24. The basic function of the stock market — bringing together buyers and sellers in an orderly fashion — had broken down.

Trades flickered across computer screens that made no sense. Shortly after 2:47, shares of Accenture PLC dropped in seconds from about $40 to one penny, then rebounded just as quickly. The explanation surfaced later: Market-making firms — regular buyers and sellers of certain stocks — have to maintain quotes at all times. To fulfill the requirement, they use ‘stub quotes,’ dummy quotes they never expect to be executed. But in the absence of buyers on May 6, computers matched automated sell orders with the dummy quotes.

Rumors swirled about of an erroneous ‘fat-finger’ order by a trader at Citigroup Inc. — that the trader mistakenly entered extra zeros, turning millions into billions. Citigroup and regulators later said such an errant trade did not appear to have taken place.

But the rumor helped stabilize the market. If the massive decline was the result of a mistake and not some terrible news, that meant there were bargains to be had.

At 2:47, the Dow reached its nadir, down 998.50 points. As trading resumed in the futures market, buyers flooded in and prices started to rebound.

Within one minute, the Dow reclaimed 300 points.

But the problems weren’t over. Exchange-traded funds, or ETFs, are baskets of securities that trade like a stock. NYSE’s Arca is usually home to 30% of ETF trading. When other exchanges stopped routing orders to Arca, the normal flow of ETF buyers and sellers was disrupted.

Two big hedge-fund and trading firms, D.E. Shaw Group and Citidel Investment Group, detected problems in Arca’s ETF computer feed. Citadel asked customers to route orders elsewhere. NYSE officials say they found no problems with Arca’s ETF platform on May 6.

Some of the biggest ETF traders are firms that try to profit from discrepancies between prices of ETFs and the stocks that they track. But as questions mounted about pricing of individual stocks, these firms pulled back from trading. This hurt small investors who had placed ‘stop-loss orders,’ aimed at protecting against big losses by automatically selling once prices fell below a certain level. Those orders hit the market when there were virtually no buyers to be found.

At 3:01, Nasdaq once again began routing orders to NYSE’s Arca.

Executives from several major exchanges joined a conference call to discuss, among other things, whether to declare some trades erroneous. After considerable debate, they decided to cancel trades in stocks and ETFs that had fallen or risen 60% or more.

In the final hour, trading remained erratic. At one point, Apple traded for nearly $100,000 a share on Arca, according to NYSE officials, after a buy order for 5,000 shares entered the market and only 4,105 shares were available. When Arca’s computers saw that no more shares were available to sell, the system automatically assigned a default price of $99,999 to the remaining 895 shares. Those trades later were cancelled.

4 p.m., Dow closes down 342 points

May 6 exposed frailties in U.S. markets that hadn’t been seen before. The SEC and Commodities Futures Trading Commission expect to issue a final report on the flash crash within a few months.

Regulators have moved to fix some problems revealed that day.

New circuit breakers, now in pilot mode, require a five-minute trading halt on S&P 500 stocks that move more than 10% within five minutes. These ‘collars’ could help keep prices from suddenly cascading.

But some forces behind the flash crash seem beyond the reach of regulators. Exchanges are unlikely to be able to prevent high-frequency trading firms or statistical-arbitrage firms from bailing out of the market en masse.

The challenge for regulators and exchange operators is whether they can find ways to protect investors in a market ever-more defined by high-speed trading. It may be that such a market is inherently vulnerable to high-speed crashes.

Tom Lauricella / Scott Patterson

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