Module 1: Investment Basics | Blog 1-5: The Flash Crash of 2010 by David Krause

On May 6, 2010, the U.S. stock market crashed. The Dow Jones Industrial Average went down about 1000 basis points (or nearly 10% of its value) in about 20 minutes, and then recovered most of those losses only few minutes later. This event is known as the “Flash Crash of 2010.” The 2014 book by Michael Lewis, Flash Boys, also highlighted the dangers of computer-driven, high frequency trading.

Flash Crash of 2010

Flash Crash of 2010

Many market followers believe that what caused the stock market to crash was sophisticated computer programs that work with complex algorithms to transact a large number of market orders at very fast speeds, known as High Frequency Trading (or HFT). In addition to HFT, Dark Pool Trading (or DPT) was also pointed as one of the possible causes of the Flash Crash. Furthermore, many investors believe that these kinds of program trading strategies are making the markets highly vulnerable and volatile; and because of this, additional regulation has been sought.

There are two possible reasons for the Flash Crash of 2010:

  1. On May 6, 2010, the global financial markets were under stress due to concern about the European debt crisis. The Euro had dropped to a new 14-month low and investors were disappointed that the European Central Bank had failed to show any concern about the Greek debt. Markets were highly volatile.
  2. There was also a large transaction made late in the trading day by an investment manager, Waddell & Reed, that triggered the Crash. The firm made a sale of 75,000 e-mini futures contracts on the S&P 500 stock index that was worth $4.1B. In addition to the large size of the order, the firm wanted the transaction to be completed as fast as possible and at any price point – triggering many other sell algorithms around the globe.

An “e-mini” is a futures contract that tracks the S&P 500 and it is traded on the Chicago Mercantile Exchange. Each 1 point move in the S&P 500 index is worth $50 per contract. Furthermore, the E-mini S&P 500 futures contract is one-fifth the size of the standard S&P 500 futures contract. Some of the advantages that this futures contract presents are greater liquidity and affordability for individual investors. A $4 billion sell order could cause short-term disruption to the pricing of this security.

The Flash Crash of 2010 was the largest intra-day point drop ever – with the major stock market indexes dropping by over 9% before a near recovery occurred only a few minutes later. Some stocks, such Boston Beer and Accenture, essentially posted a near 100% decline and rise during this short period. Even the giant firm, Procter & Gamble, saw it’s stock price plummet during the ‘crash’ – dropping by nearly 40% in the course of a few seconds.

High Frequency Trading, which is seen as one of the possible causes of the Flash Crash, involves the use of quantitative computer programs to hold short-term positions in all kinds of financial instruments that can be traded electronically such as equities, options, futures, ETF’s and currencies. Hedge funds and investment companies that own these sophisticated computer platforms aim to capture just a fraction of a cent per share or currency unit on every trade. These transactions take place many times a day, and these fractions of a penny accumulate quickly, which can lead to posting significantly positive profits at the end of every day. HFT supporters say that this trading promotes markets by making them more liquid, and as a consequence it reduces the overall cost of capital.

The whole concept of High Frequency Trading is based on the idea that programmed computers can be better traders than humans. Computers process and analyze data in a faster fashion than the human brain does, and that is the reason why many big firms are choosing this way of trading. Algorithms are the programs that trigger these rapid trades.

Nowadays, HFT of equities require more technical, rather than fundamental, analysis. And with the huge volume traded through HFT platforms (it is believed that this accounts for more than 60% of all futures volume traded and roughly 50% of all trading) mistakes can be made. After all, how could the value of one of the largest, most stable firms in the world (Procter & Gamble) drop 40% within a matter of seconds?

Dark Pool Trading is also pointed as one of the possible causes for the Flash Crash of 2010. DPT gives access to trading opportunities for institutional investors that are not available to the public. Electronic trading and sophisticated platforms have made this kind of trading become possible through crossing networks.

The key benefits of trading in Dark Pools that are cited include the ability to trade a large volume of stock quickly, providing better liquidity to institutions, and also lowering trading costs. However, even though Dark Pools benefit financial institutions with price improvement and better liquidity, this kind of trading may also increase market volatility and impair the ability of individual investors to get the best deal at the best price.

After the Flash Crash, many in the investment community sought help from the Securities and Exchange Commission (SEC) to set up some sort of regulation on transactions made by HFT and DPT so that what happened in 2010 would not happen again. Since then the SEC has been active in trying to implement “single-stock circuit breakers” that would stop trading made by computerized systems after they trade large volumes of stocks. Additionally, a Market Access Rule was adopted by the SEC that requires dealers and brokers to “implement controls and supervisory procedures to manage the financial and regulatory risks of market access, including the risks of errant trading algorithms that could seriously disrupt the markets.”

Will this stop another Flash Crash from occurring? The answer is that we do not know and therefore it is easy to see why many continue to seek additional regulation on HFT and Dark Pool transactions.

Additionally, it is important to note that there has been more than one ‘crash’ since sophisticated trading platforms appeared. In fact, as recently as April 23, 2013, the Associated Press had its Twitter hacked – and a posting appeared that there was an explosion in the White House and that President Obama was injured – which made the market plunge by over 1% within seconds. Again, many fingers pointed at HFT.

Tweet Mini-Crash of 2013

Tweet Mini-Crash of 2013

Therefore, it is important that the entities that regulate the market pay close attention to these computerized systems and how these can have a negative impact in the market. Are more regulations needed – or will technology and market efficiency prevent future ‘Flash Crashes’ from occurring? We’ll have to wait to see!

 

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