Can Anything Be Done To Prevent A Second Flash Crash?

May 6th, 2010 lives in infamy in financial markets; a precipitate dive on the US stock market wiping a trillion dollars off the value of equities in just under 30 minutes stunned the industry.

The speed at which such an astonishing crash took place was partly in thanks to the ever-shrinking timeframes in use in electronic trading methods such as algorithmic and high frequency trading (HFT).  These techniques eventually find a welcome home in many markets due to lower costs, smaller spreads, and the ability to capture alpha.  But the damage that results when automation goes awry - or is used improperly - shows that high speed trading does require high speed controls. 

As the days and weeks wore on after the flash crash, regulators realized that they had neither the tools nor the authority to look closely enough and explain what had happened. HFT and algorithmic trading were so embedded in daily market transactions that the volume of trades simply could not be tracked easily.

Since the flash crash, US regulators have been traveling two roads.  On one road, the regulators remain focused on cleaning up domestic equities trading, to prevent another flash crash.  On the other road, regulators are reforming OTC derivatives trading in response to the global financial crisis, by mimicking the market structure and transparency of the equities market, as if the flash crash had never happened. Meanwhile, markets have continued to evolve as HFT continues to spread out across exchanges around the world.

Not only are algorithmic and high frequency trading taking a growing share of activity in equities, but they are also spreading into other asset classes, such as commodities, currencies, and a wide variety of complex derivatives. The proliferation of HFT in new asset classes begs the question: are we now headed for a second flash crash?

The honest answer is: probably. And not just in equities. The interdependence between some of these asset classes also means that the crash could 'splash' across them. The use of high frequency trading strategies has already achieved dominance in stock exchanges, and migration into other asset classes and other national markets causes concern. For example, we have already seen algorithmic trading spreading beyond equities and commodities to currencies and fixed income.

A mini flash crash in Japanese yen in March was eerily reminiscent of the May 6th equities crash. If liquidity in the FX market, which trades trillions of dollars daily, could instantly dry up then there is clearly a need for better monitoring and controls in that asset class.

Measures needed to prevent a second flash crash from taking place include both regulation and technology. Market surveillance and monitoring across the board has to include regulators, trading venues, and brokers in order to be effective.

Being responsive - and responsible - means being proactive; measures have to be put into place before the next flash crash. To make this happen, sophisticated real-time surveillance is a must for monitoring anomalous market patterns, including abuses and errors; for checking sponsored access clients' credit risk; and for balancing market position limits. None of these techniques replace the need for standard compliance tools such as historical looks and material penalties for those who stray from regulatory mandates.  But the flash crash has showed that there’s an additional need to protect our markets from the damage that can’t be fixed at the end of the day.  Don't wait until it is too late, that's like driving while looking in the rear-view mirror.

-Dan