The Internalizers and The Flash Crash; Let’s Talk Real Villains

Sal Arnuk
Themis Trading LLC
10 Town Square, Suite 100
Chatham, NJ 07928


By now every world citizen who has ever owned any stock knows “Waddell” as a household word. The regulators do not name them specifically in their October 1st SEC/CFTC Flash Crash Report (available here), yet the firm’s identity might just top the world’s worst-kept-secret list. If there were not enough references to Waddell and Reed over the weekend on Twitter and thousands of blogs, Dave Cummings, owner the HFT powerhouse Tradebot may have rectified that with his letter to the street, titled “Waddell Stupidity Caused The Crash” (available here).

Waddell is blamed for unleashing an algorithmic percentage-of-volume order to sell 75,000 E-Minis that everyone seems to be crediting for the Flash Crash. Don’t take the bait. This is as good a diversion, and example of misdirection, as we have ever seen. Consider the following:

– 35,000 contracts were sold on the ways down; 40,000 were sold on the rebound after the CME’s 5 second trading pause. This should be pointed out as everyone is citing 75,000 contracts (the total).

– It was 9% of the volume while it was active (during the period about 833,000 contracts traded.

– S&P E-Minis are among the world’s most liquid instruments.

We are saddened that nowhere in the public discussion is the role that internalization firms (OTC Market Makers) played in the day’s unraveling. Internalizers, a term the SEC is using in its Flash Crash Report, handle individual investor retail market orders. (For example, you can look on Ameritrade’s 606 report for Q2 2010, and see that 83% of market orders are sold to Citadel for about .0015/share on average.)

Typically, the internalizer then takes the other side of the trade for “a very large percentage” of this flow. On May 6th, the SEC found that there was a departure from this practice (see page 58 of the SEC Report). As the market was falling dramatically, the internalizers (we don’t know which internalization firms the SEC is referring to) continued to short stock to retail market buy orders, but they dramatically stopped internalizing retail market sell orders, and instead flooded the public market with those orders. When the market stopped falling, and rose dramatically almost as quickly as it fell, the internalizers reversed that pattern, and internalized retail sell market orders, and flooded the public market with retail market buy orders. To restate this plainly, the internalizers used their speed advantages to pick and choose for its P/L which orders it wanted to take the other side of. For the ones they did not wish to take the other side of, they routed them to the markets as riskless-principal trades. The practice not only strikes us as patently unfair, but the number of orders that flooded the marketplace was massive. As such it caused data integrity issues (widening the difference between speeds of the CQS public data and the co-located data), further perpetuating the downward cycle in the marketplace.

In addition, we point out the SEC‘s findings on page 65, as they discuss broken trades, and the large amount attributed to internalizer:

“Many internalizers of retail order flow stopped executing as principal for their customers that afternoon, and instead sent orders to the exchanges, putting further pressure on the liquidity that remained in those venues. Many trades that originated from retail customers as stop-loss orders or market orders were converted to limit orders by internalizers prior to routing to the exchanges for execution. If that limit order could not be filled because the market continued to fall, then the internalizer set a new lower limit price and resubmitted the order, following the price down and eventually reaching unrealistically-low bids. Since internalizers were trading as riskless principal, many of these orders were marked as short even though the ultimate retail seller was not necessarily short. This partly helps explain the data in Table 7 of the Preliminary Report in which we had found that 70-90% of all trades executed at less than five cents were marked short.

Furthermore, in total, data show that internalizers were the sellers for almost half of all broken trade share volume. Given that internalizers generally process and route retail trading interest, this suggests that at least half of all broken trade share volume was due to retail customer sell orders.”

Even more disturbing was this:

“Detailed analysis of trade and order data revealed that one large internalizer (as a seller) and one large market maker (as a buyer) were party to over 50% of the share volume of broken trades, and for more than half of this volume they were counterparties to each other (i.e., 25% of the broken trade share volume was between this particular seller and buyer.”

Since we all know the name of Waddell, shouldn’t we also know the name of the ONE market maker and the ONE internalizer who were responsible for more than 50% of the volume of broken trades?

Retail investors were clearly the biggest loser on May 6th. They trusted that their brokers would execute their orders in a fair and efficient manner. However, considering that half of all broken trades were retail trades, and that the arbitrary cutoff was 60% away from pre flash crash levels, the retail investor ended up paying the highest price for the structural failings of our market.


Sal L. Arnuk ( is co-head of the equity trading desk at Themis Trading LLC (, an independent, no conflict agency brokerage firm specializing in trading listed and OTC equities for institutions. Prior to founding Themis, Sal and Joe worked for more than 10 years at Instinet Corporation, pioneers in the field of electronic trading, and at Morgan Stanley.

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