How the 'Flash Crash' Echoed Black Monday

May 6 Selloff Had Parallels to 1987; Electronic Trading Magnified Selling Pressure This Time

By SCOTT PATTERSON

Soon after the Black Monday crash of 1987, exchanges and regulators scrambled to enact new rules to prevent a repeat of the biggest stock market shock in 50 years. Even then, they worried they hadn't done enough.

"I simply cannot give you assurances that we have fixed the system," the chairman of the Securities and Exchange Commission at the time, David Ruder, told the Senate Agriculture Committee in early 1988.

After two decades of rule-changing and technological advancements, those comments seem haunting, especially as investigators of May 6's "flash crash" stumble upon echoes of the Black Monday meltdown.

Technological innovation has been widely touted as having made the market more efficient, and more resilient. Instead, the May 6 drop—while much smaller than the 1987 crash—showed that technology mainly served to speed up trading and magnify the market moves.

On May 6, "The velocity of the volatility was stunning, beyond anything I had ever seen, with the exception of October of 1987, when I was on the trading floor," said Ted Weisberg, president of Seaport Securities in New York.

"There's a strong parallel between the Black Monday crash and the flash crash," said Michael Wong, an analyst at Morningstar who tracks stock exchanges.

On Oct. 19, 1987, the Dow Jones Industrial Average tumbled more than 20%, and the swoon extended into the following day, before a rebound. Floor traders, working by telephone, dominated the action and computer-generated trading was still in its infancy. Dark pools and high-frequency trading were the stuff of science fiction. Trading reached 600 million shares, according to the SEC.

Fast forward to May 6, 2010: The worst part of the lightning descent lasted roughly 10 minutes and the decline hit 9.8% at its worst. Trades, many executed in milliseconds, reached 19 billion shares.

In both cases, troubles first appeared in the stock futures market, which precipitated a decline in the regular "cash" market. The two created a feedback loop, dragging both markets lower.

Perhaps the most concerning parallel was how professionals abandoned the market. In 1987, some human market-makers on the floor of the exchange stopped providing bids for certain stocks.

Two decades later, in a market dominated by technology, high-speed traders who often provide liquidity for the market, just switched off their computers. Other big players, including fast-trading hedge funds, also pulled out of the market, according to traders and exchange officials.

"Go back to the 1987 crash, every major firm pulled out," said Chris Concannon, a senior partner at Virtu Financial LLC, a New York electronic market making firm, which continued trading during the May 6 turmoil. "In every break you find evidence of major firms withdrawing their buying and selling interest from the market."

Ahead of Black Monday, many agreed the market was due for a slide, having staged a 40% run-up earlier that year, part of a bull run that had started in 1982. And in the past 12 months, many market observers watched warily as the Dow staged a 60% rally from its lows of March 2009.

On the morning of Black Monday, futures contracts dropped sharply before the start of regular stock trading on the floor of the New York Stock Exchange. When New York opened, stocks plunged to reflect the lower futures prices.

That led to more futures selling. A relatively new financial product in the 1980s called portfolio insurance, in which investors used futures to hedge against losses in stocks, amplified the downdraft. Heavy selling of futures pushed down stock prices. Investors looking to protect themselves from further losses in stocks in turn sold futures—sparking another wave of stock selling.

While portfolio insurance has long since gone by the wayside, a large number of traders still use futures to hedge against losses. The May 6 selloff appears to have been led by a wave of futures selling. Commodity Futures Trading Commission Chairman Gary Gensler, in congressional testimony a week ago, said trading between futures and stocks became "highly converged" in the May 6 decline. The plunge in futures caused stocks to fall, leading to even more selling of futures.

The link means that in times of stress, these two key parts of the market—stocks and futures—can have a self-reinforcing effect that can turn an average selloff into a crash.

Selling pressure on both days became so intense that any remaining buyers were overwhelmed, creating an "air pocket" in stocks and other securities that led to vertiginous declines.

Many market makers on Black Monday had exhausted their funds, while others were overwhelmed by the volatility. The NYSE later took steps to boost traders' capital.

Some of the key changes in the markets helped magnify the selling pressure on May 6, rather than helping cushion the market.

This time around, many investors rushing to sell unloaded exchange-traded funds, which didn't exist in the 1980s.

Heavy selling of ETFs spread losses to other parts of the stock market. ETFs linked to indexes such as the Russell Midcap index spiraled in value in the selloff; indeed, the value of many ETFs actually fell to pennies. About two-thirds of all securities that had canceled trades on May 6 were ETFs, according to IndexUniverse.com.

Yet there is one last parallel between 1987 and 2010. Mr. Ruder, the former NYSE head and currently an emeritus professor at Northwestern University, is now part of the government committee examining the "flash crash."