Monday, June 21, 2010

Flash Crash: Is Another One Coming Soon?

Some of you have asked for my reasons to stop posting new entries on the blog.

Without going into the details, let it suffice to say that after the “flash crash” of May 6th I wanted to take some time off to re-group, re-strategize and get a fresh perspective on all things related to financial matters.

The “flash crash” of May 6th, when the DOW dropped over 1,000 points in a few minutes, may be history but its after-effects—and threat to the global stock markets—continue to haunt further with two recent mini-crashes in individual stocks.

Regulators have characterized the initial flash crash, as a one-off occurrence possibly attributable to a "fat finger" trade or some other market anomaly… and to this day, regulators are still not sure what caused it.

Growing number of traders and regulators believe the flash crash is symptomatic of a larger problem with high-frequency trading, derivatives trading, and a very complex market that lacks visibility and is susceptible to similar events in the future.

Thus far, the main reaction has been the implementation of circuit breakers that stop trading on individual stocks should they rise or fall more than 10 percent in a five-minute span.

The rule, implemented for a six-month test period, played out its part twice over the last few weeks. First, it was when Washington Post [WPO] shares doubled inside of a few seconds on June 16th, from nearly $460 to $929.18. Trades totaling 766 shares at $929.18 crossed on NYSE Euronext’s NYSE Arca platform at 3:07:30 p.m. in New York, data compiled by Bloomberg show. The stock changed hands for $462.84 prior to the jump. The orders, later canceled, triggered a five-minute halt under rules adopted after the May 6th flash crash… which erased $862 billion from U.S. stocks in less than 20 minutes.

The circuit breakers essentially did their job, halting trading in the company after the surge. But the mystery remains over why such events happen in the first place. While the regulations didn’t prevent the erroneous orders from being placed, they may have kept more shares from being bought and sold at prices that would later have been voided.

Tech services company Diebold [DBD] saw its shares plunge 35 percent then recover in a period of a few minutes on June 2nd, before the circuit-breakers kicked in. The plunge in Diebold shares that erased 35 percent of its market value in six seconds is under review by U.S. regulators, people with direct knowledge of the investigation said. The stock dropped $8 in six seconds to $18.26 before recovering to above $25 a minute later, Bloomberg data show. Four-hundred twenty-seven trades occurred in Diebold shares below $23 totaling about 113,600 shares, according to Bloomberg data. All of them took place on electronic venues such as Nasdaq and Bats Exchanges.

The non-transparency that stems from high frequency trades, which can happen in milliseconds, makes tracking the trades virtually impossible. Some estimates have high-frequency trading accounting for about 70 percent of all market activity. Defenders of high-frequency trading say it pumps liquidity into the markets and makes fair trading possible. But perhaps the most stunning characteristic of the May 6th flash crash was that liquidity actually evaporated from the market, sending shares of some big-name companies momentarily to a penny when they couldn't find a bid.

“Exchange traded funds as a class were more affected by the flash crash of May 6th than any other category of securities," the Investment Technology Group said in an analysis.

Most traders still believe that the integrity of the market is intact and investors have little to fear, even though there's little reason to believe future flash crashes won't happen.

With that in mind, I’m back in the saddle for another ride on this roller coaster.

Anant Goel