It has been one year since US investors were spooked by the so-called “flash crash.” Could it happen again? Yes, it could.
With that in mind, investors may want to recall Reinhold Niebuhr’s “Serenity Prayer”, which asks for the “serenity of mind to accept that which cannot be changed; courage to change that which can be changed; and wisdom to know the one from the other.”
Financial markets – particularly over the past few years – have been far from serene. But Niebuhr’s entreaty is relevant for policymakers and market participants alike. Over the past year, our exchanges and the Securities and Exchange Commission (SEC) have taken a series of actions to address problems uncovered on May 6 last year, while avoiding damaging attempts to change the unchangeable.
Let’s recall the events of that day. A jittery macroeconomic environment – a weak euro and a debt crisis in Greece, plus volcanic eruptions in Iceland and a worsening oil spill in the Gulf of Mexico – took markets down 3 per cent by mid-afternoon.
Liquidity suppliers pulled back throughout the day to reduce risk. Notwithstanding this fragility, an investor placed a sizeable, 75,000-contract sell order on CME’s e-mini S&P 500 futures contract at roughly 2:30pm New York time. Initially, the order took scarce liquidity from the market and contributed to a further 6 per cent fall. At 2:45pm, CME’s matching engine took a 5 second pause. When it resumed trading, futures rallied, the order was completed, and the market returned to earlier levels.
If the futures market was a rollercoaster, the equities market was a train wreck. Reacting to the action on the CME, many equity liquidity providers withdrew from the market. Others reduced capital commitments. As sellers continued to access the marketplace, a “liquidity crisis” ensued and orders were executed at absurd prices.
A few hours after the close, exchanges jointly announced that trades at prices 60 per cent or more away from the market before the downdraft would be broken. Exchange-traded funds (ETFs), an innovative and growing market segment over the past decade, were hit particularly hard, with many ETF values dramatically, if briefly, decoupling from their underlying assets.
Allegations swirled about the causes of the flash crash. Debate ensued about what to do next. Understanding that liquidity crises are usually more a function of trading behaviour than market structure, the SEC brought the exchanges together to take three incremental steps to limit the possible fallout from similar circumstances in the future.
In June, exchanges implemented single-stock circuit breakers to pause trading when prices become excessively volatile. In September, exchanges adopted procedures to identify and break clearly erroneous trades in a timely and consistent fashion. In December, exchanges implemented uniform standards to require market makers to provide continuous quoting at 8 per cent or better outside the best price.
Industry work continued into this year. The SEC is considering a “limit up/down” mechanism to make the current single-stock circuit breakers more operationally efficient and less disruptive of price discovery. The SEC is reviewing the current broad-market circuit breaker, implemented after 1987’s market break but ineffective on May 6, in conjunction with the Commodity Futures Trading Commission (CFTC).
The SEC is also refining its consolidated audit trail proposal. By providing regulators with comprehensive data in a cost-effective fashion, the industry can ensure that the “cop on the beat” has the proper tools to enforce the rule of law. Regulators must respond in kind to develop analytical expertise to make full use of this powerful resource.
Equally important as the actions taken are those skipped. Commendably, the SEC has avoided a number of pitfalls, despite lobbying from certain circles. It did not slow down the market, which would raise the cost of liquidity and make our markets less attractive for capital formation. It did not engage in prescriptive, heavy-handed regulation of institutional algorithms, which would choke a competitive and innovative element of the marketplace that has been instrumental in driving down trading costs and improving productivity for money managers. And the SEC did not impose overly stringent standards for market makers, which would limit competition among liquidity providers by raising barriers to entry.
So will these judicious actions by regulators stop another flash crash? Unlikely. History suggests that May 6 was more about behaviour than market structure: the NYSE experienced a similar liquidity crisis in May 1962, when high-frequency trading meant using Bakelite telephones and long before NYSE’s centrality yielded to a competitive, if fragmented, network of market centres. Postmortems by regulators confirm this view.
But to a large extent, that question misses the point. The challenge before the industry and our regulators is to make incremental market structure changes to limit impact of any future flash crashes. Mustering both serenity and wisdom, we should be humble about our ability to legislate changes in behaviour.
Jamie Selway is a managing director at Investment Technology Group in New York