Table of Contents
What is a Flash Crash?
A flash crash refers to a sudden sell-off of securities, causing market values to plummet. Flash crashes highlight the volatility of electronic trading as markets will drop and recover by the end of the trading day. The flipside of a flash crash—a sudden increase in market value—is sometimes referred to as a flash spike.
Although previous stock market crashes had occurred (e.g., Black Monday), the first Flash Crash (sudden loss AND rapid recovery) happened on May 6, 2010. The Dow Jones Industrial Average (DJIA) fell around 800 points in just 10 minutes, costing $1 trillion in equity. Nevertheless, by the end of the trading day, the DJIA had recovered most of its lost value.
In this article, the Zero Theft Movement will cover the phenomenon of the flash crash, examine the specific case of the 2010 Flash Crash, and explain concerns these events raise.
A 2017 Forbes article reports, “For most of the 20th century, stock buybacks were deemed illegal because they were thought to be a form of stock market manipulation. But since 1982, when they were essentially legalized by the SEC, buybacks have become perhaps the most popular financial engineering tool in the C-Suite tool shed…Buying back company stock can inflate a company’s share price and boost its earnings per share — metrics that often guide lucrative executive bonuses.” See what the ZT community has uncovered about stock buybacks…
Understanding a Flash Crash
Electronic trading has boomed with the developments in technology. The industry’s shift to computerization has not only made the stock market much more accessible to the Main Street investor but also allowed Wall Street traders to use complex algorithms to maximize their gains. High-frequency trading (HFT), for example, can make millions of trades in milliseconds. Such rapid, high-volume trading can lead to flash crashes in the stock market.
While human error is a very real thing, so is ‘computer error.’ Glitches, faux pas, and even flash crashes have posed (relatively) new problems in our high-tech world. Hedge fund darling Long-Term Capital Management, for example, collapsed due to over-reliance on complex computer models. Global exchanges such as NASDAQ continue to adapt to the rapid rise of new technologies, and have established safety mechanisms, or ‘circuit breakers’ to prevent significant losses. Some believe that the Plunge Protection Team has a hand in stabilizing markets when necessary.
The Flash Crash 2010
Source: R-Bloggers
From the morning of May 6, 2010, trading on major U.S. markets was dipping. The Greek government-debt crisis and UK PM elections that year had led the finance industry to expect such fluctuations. Nevertheless, come afternoon, major indices had dropped 4% from the close of the previous trading day.
With hearts in throats, traders exacerbated the overall volatility of the markets. They obviously did not want to be on the losing end. The added instability sent the DJIA spiraling close to 1,000 points in a matter of a few minutes. It, for the most part, recovered immediately. The whole incident took about 15 minutes. Hence, the term “Flash Crash.”
According to a joint investigation by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), a $4.1 billion sale triggered HFT supercomputers to buy and resell EMini contracts. The rapid recovery came after high-frequency traders had paused their trading to deter further losses. Insead Knowledge estimates that the biggest single victim of the 2010 Flash Crash overpaid for his trades somewhere in the range of US$98.6 to $229.8 million.
In 2016, a Department of Justice (DoJ) press release announced that futures trader Navinder Singh Sarao had pled guilty to “illegally manipulating the Futures Market in Connection with [the] 2010 ‘Flash Crash.’” The press release details the alleged market manipulation as follows:
“As part of his guilty plea, Sarao admitted that he used an automated trading program, along with other techniques, to manipulate the market for E-mini Standard & Poor’s (S&P) 500 futures contracts (E-minis), stock market index futures contracts based on the S&P 500 index, through the Chicago Mercantile Exchange (CME). The E-mini S&P 500 is considered among the most widely traded financial products in the world. Sarao admitted that he placed thousands of orders that he did not intend to trade, or “spoof orders,” to create the appearance of substantial false supply and demand and to induce other market participants to trade E-minis at prices and quantities they normally would not have traded. In thousands of instances, Sarao admitted, he was able to induce other market participants into buying or selling E-minis by placing the spoof orders, which had the additional purpose and effect of artificially depressing or artificially inflating the price of E-minis. On the day of the “Flash Crash,” Sarao entered at least 85 spoof orders to sell E-minis, which, at various times throughout that day, represented well over 20 percent of all E-mini sell orders visible to the market, he admitted.”
According to news reports (BBC, The New York Times, Bloomberg), Sarao did not serve more than four months in prison. The BBC report stated: “prosecutors ultimately decided not to push for a jail sentence, as Sarao didn’t spend the money on any luxuries and had quickly lost his windfall to fraudsters. They also took into account his autism, time in jail already served, and that he has been helpful to the government for several years since then.”
Flash Crash Concerns
Recession
Large trade blocks can set off flash crashes. Electronic trading, especially high-speed trading, can simply exacerbate matters. These complex algorithms detect aberrations and immediately sell off holdings to prevent losses, sending prices spiraling. As fallible as humans are, perhaps you need them to at least properly monitor their algorithms. At least until a better code is devised.
A major concern of a flash crash is that, in the right(?) conditions, it could trigger a recession. If major volatility occurs on a daily basis, how could investors have confidence in markets? They would likely pull out their investments and/or stop making additional investments. Furthermore, depending on where the economy is in its boom and bust cycle, a flash crash could be that spark to set off a huge decline.
HFT Frontrunning
Flash crashes have also raised concerns about whether the stock market is rigged to favor high-frequency trading firms. In the mid 2010s, Brad Katsuyama, former Royal Bank of Canada trader, spearheaded the independent investigation into why his orders were not being fulfilled. He said the following in a quote for The Verge, “They [high-frequency traders] could detect my order at BATS [a global stock exchange], race me to the next exchange, and cancel their sell orders while buying whatever is left, then turn around and try and sell stock back to me at a higher price.”
CBS’s Sixty Minutes met with both Katsuyama and Michael Lewis, the author of Flash Boys: A Wall Street Revolt. Lewis had written a book chronicling Katsuyama’s discovery and unearthing alleged front running through HFT and private exchanges (i.e., dark pools). In the video just linked, the award-winning television series explains the supposed scheme as follows:
“It only took a tiny fraction of a second for Brad’s trade to reach the next exchanges on the network. But the high speed traders were able to jump in front of him, buy the same stock, and drive the price up before his order arrived. Producing a small profit of just one or two pennies. But it was happening to everyone’s trades millions of times a day.”
With supercomputers running complex algorithms, there’s absolutely no way most investors can compete. Not just Main Street investors, but also professional traders such as Katsuyama who worked for a major global bank. He, in his interview for Sixty MInutes, says, “We found a problem that’s affecting millions and millions and millions of people. People are blindly losing money they don’t even know they’re entitled to.”
Dark pool trading accounts for ~30% of all trading. Do you think billions of concealed trades could be happening without us even knowing it? Find out what your fellow citizens have uncovered…
What should be done about the Flash Crash Problems?
“This form of front running is legal. It’s legalized front running. It’s crazy that it’s legal for some people to get advanced news on prices and what investors are doing.”
Michael Lewis
Electronic trading has many benefits, some of which we’ve already mentioned earlier. Its convenience and accessibility enable the public to get into investing earlier on in their lives. Nevertheless, it does come with major concerns. Particularly the potential problems surrounding HFT.
For most, if not all, of us, we will never be able to execute trades as fast as these computer programs can. The majority cannot afford such a supercomputer anyway. You can protect your assets and retirements by hedging and playing the long game. Also, we can help educate future generations on proper money management practices, so they can live a healthy and secure life in retirement.
Apart from how we can protect our own investments, we should be challenging our legislators and Wall Street regulators. While the SEC has established circuit breakers to help prevent flash crashes, are they really enough? Should supercomputers and algorithmic trading even be allowed? Does it give an unfair advantage, where HFT firms can manufacture unethical arbitrage opportunities that rip off the public?
The Zero Theft Movement provides a platform where you and your fellow citizens work together to investigate and debate potentially rigged areas across the economy. You decide whether (1) theft is or isn’t occurring in a specific area of the economy, and (2) how much is being stolen or possibly saved. Through direct democracy, we can collectively decide where the problem areas are and start working on addressing them systematically.
Standard Disclaimer
The Zero Theft Movement does not have any interest in partisan politics/competition or attacking/defending one side. We seek to eradicate theft from the U.S economy. In other words, how the wealthy and powerful rig the system to steal money from us, the everyday citizen. We need to collectively fight against crony capitalism in order for us to all profit from an ethical economy.
Terms like ‘steal,’ ‘theft,’ and ‘crime’ will frequently appear throughout the article. Zero Theft will NOT adhere strictly to the legal definitions of these terms (since congress sells out). We have broadly and openly defined terms like ‘steal’ and ‘theft’ to refer to the rigged economy and other debated unethical acts that can cause citizens to lose out on money they deserve to keep.