How futures trading could crash stocks

The US equity market 'flash crash' of May 6 2010 has long highlighted the pronounced link between futures exchange contracts and the share prices of companies bought and sold by investors of all stripes.

Regulators digging into what sparked an abrupt collapse of share prices, where the likes of Accenture briefly traded at 1 cent per share before a stunning rebound inside twenty minutes, concluded back in 2010 that trading via equity futures in Chicago was the spark that had lit the flash crash fuse.

Now the US Department of Justice has alleged that a UK-based trader contributed by manipulating the trading in S&P 500 equity contracts, known as e-minis, which are listed on the Chicago Mercantile Exchange.

The CME launched the e-mini as an electronic contract in 1997, with a lower size than the standard S&P 500 futures contracts that were being transacted on its trading floor in open outcry pits by traders gesticulating furiously with elaborate hand signals.

The e-mini contract's cut-down size reflected the view that electronic trading prospers with smaller trade lots and the market duly flourished. The e-mini tracks the world's largest equity market, which includes the top 500 US companies with a combined market capitalisation of $19.2tn. The CME has subsequently expanded its list of e-mini contracts across a range of financial markets.

The trading of e-mini S&P 500 contracts also occurs over 23.5 hours of the day, beyond the normal trading hours of 9:30am to 4:00pm in New York for listed cash equities. The futures contract thereby provides investors across the world with a liquid and fast way to trade US equities across computerised systems. Many professional investors rely on S&P e-minis to insulate their portfolios of stocks against sudden and large changes in the broad market.

The e-mini contract thus acts as a key gauge of sentiment before and after the cash equity market's usual trading hours. However, futures trading - like other markets - has also been associated with efforts by some traders to manipulate prices using techniques such as spoofing, layering prices and front-running.

Moreover, the 1987 stock market crash was blamed in part on investors selling equity futures to protect themselves against losses, known as portfolio insurance.

Thanks to the pronounced rise of electronic trading across US equities since 2007, the links between futures and cash shares have never been so strong in terms of reaction and trading volumes.

Back in October 2010, US regulators issued a 104-page report that said the trigger for the flash crash was the sale of 75,000 e-mini futures contracts on the S&P 500 stock index, worth $4.1bn.

The ensuing evaporation of buyers for the e-mini contracts pushed prices sharply lower and created a liquidity crisis, compounded in seconds by high-powered computerised trading systems. Once so-called high-frequency trading systems saw the large sell order, they pulled back and exited the market, contributing to a rapid decline in futures and cash equity prices.

The pronounced electronic link between trading futures and cash-based equities meant that the evaporation of liquidity in Chicago instantly swept across computerised systems and across the trading floor of the New York Stock Exchange and Nasdaq.

The repercussions of the flash crash included the introduction of circuit breakers to halt trading in US companies should their price change too quickly, and calls for regulating high-speed trading of so-called high-frequency trading firms.

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