29 October 2019 Issue Brief

Flash Crashes

A so-called Flash Crash is a sudden crash or fall in stock prices. Flash crashes are the sources of increasing concern among financial market practitioners and regulators because pinpointing their causes is difficult. One theory lays some or even much blame at the feet of high-speed electronic traders, arguing that the space previously occupied by bank traders has been colonized by algorithmic traders. These traders use computers to execute trades automatically and at high speed. But their defining feature is their slim levels of capital and their ability to change their trading strategies. In quiet times, algorithmic traders are contrarians: buying when the market is falling and selling when the market is rising. Their behavior adds to liquidity. When the market starts to trend, these “algos” often switch into trading faster than others or more aggressively in the same direction of the trend. Selling more or before others drains liquidity and can create a flash crash.

On Monday, August 24, 2015, the U.S. equity markets and equity-related futures markets experienced unusual price volatility. Prior to 9:30 am, the most actively traded equity product – the SPDR S&P 500 ETF Trust – declined to more than 5% below its closing price on the previous trading day. The most actively traded equity-related futures contract – the E-Mini S&P 500 – declined to its limit down price of 5% below the previous trading day’s closing price and was paused for trading from 9:25 am to 9:30 am.

At 9:30, the SPDR S&P 500 ETF Trust opened for regular trading hours at 5.2% below its previous day’s close and then further declined to a daily low of 7.8% by 9:35. By 9:40, the ETF recovered past its opening price and eventually closed down 4.2%.  The SPDR S&P 500 ETF Trust’s decline from previous day close to August 24 open was the second largest in the last decade, while its decline from previous day close to August 24 daily low was the 10th largest in the last decade.  From 9:30am to 9:45am more than 20% of S&P 500 companies and more than 40% of NASDAQ-100 companies reached daily lows that were 10% or more below their previous day’s closing price, according to market reports.

May 2010

On May 6, 2010, U.S. stock markets opened and the Dow was down, and trended that way for most of the day on worries about a debt crisis in Greece.  In the mid-afternoon, with the Dow down more than 300 points for the day, the equity market began to decline rapidly, falling an additional 600 points in 5 minutes for a loss of nearly 1,000 points for the day by 2:47 p.m. Twenty minutes later, by 3:07 p.m., the market had regained most of the 600-point loss.

The May 6, 2010, Flash Crash was an estimated one trillion-dollar stock market crash, which lasted for approximately 36 minutes.

Flash crashes are not only more frequent but they are occurring in markets where stability is both expected and critical to the smooth function of market economies. The German government bond market, for example, which is the base for determining the interest rate payable for debt in Europe, experienced a flash crash on 15th January 2015. Outside of Europe, more financial contracts derive their price from the US government bond market than from any other, but even the Treasury market proved susceptible to a flash crash on 15th October 2014.

The Treasury Department said in a July 2015 report on that crash that the market for U.S. Treasury securities, futures, and other closely related financial markets experienced an unusually high level of volatility and a very rapid round-trip in prices. Although trading volumes were high and the market continued to function, liquidity conditions became significantly strained. The yield on the benchmark 10-year Treasury security, a useful gauge for the price moves in other, related instruments that day, experienced a 37-basis-point trading range, only to close 6 basis points below its opening level. Intraday changes of greater magnitude have been seen on only three occasions since 1998 and, unlike October 15, all were driven by significant policy announcements. Moreover, in the narrow window between 9:33am and 9:45 a.m. ET, yields exhibited a significant round-trip without a clear cause, with the 10-year Treasury yield experiencing a 16-basis-point drop and then rebound. For such significant volatility and a large round-trip in prices to occur in so short a time with no obvious catalyst is unprecedented in the recent history of the Treasury market.

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