A recent academic study describes the flash crash in May 2010 as an unintended consequence of a market risk control tool, the signaling effect of asset liquidity, and suggests a potential correction in the operations of exchanges.
In exploring what caused the flash crash in May 2010, the author shares the findings of Giovanni Cespa (Cass Business School) and Thierry Foucault (HEC Paris). In research they published in May 2012, they attributed the pandemic-like effect of sudden price collapses to misinterpretation by market participants of liquidity signals provided by proxy assets. They also suggested an optimal protection against such unexpected volatility.
How Is This Article Useful to Practitioners?
The author focuses on the paradox of how pre-emptive, ostensibly prudential safeguards can be self-defeating. Investors monitor the liquidity characteristics of asset classes relevant to their underlying holdings. A liquidity shock striking these proxies warns investors to take compensating action against existing exposures to shelter holdings from pending reverberations.
The problem is that widespread reactions can be sparked by faulty signals—particularly such idiosyncratic nonfundamental factors as computer glitches or incorrectly executed large trades. This contagion becomes a self-fulfilling event as investors rush to sell their holdings. Recent market innovations for price discovery, such as high-frequency trading, offer no protection from being similarly compromised by collapsed liquidity. The evaporation of exchange-traded fund trading during the flash crash is highlighted as an example of this effect.
The author notes that most markets now have circuit breakers that halt trading when prices drop dramatically. In addition, Cespa and Foucault advocated for an analogous layer of liquidity circuit breakers that would be activated when huge imbalances occur in buy and sell orders that could lead to exaggerated price movements. Such a breaker already exists on the Chicago Mercantile Exchange, and they believe similar stopgaps can be implemented elsewhere.
It is sound advice to look before you leap to avoid a false sense of security from protections against adverse market effects, such as sudden liquidity shifts. Regarding the suggested remedy of more exchange regulations, it also seems wise to consider the source of what is uncontrollable. As a recent CFA Institute report about dark pools noted, with more transactions migrating off exchanges, attention also needs to be devoted to those types of transactions to increase the likelihood of smoothing out potentially arbitrary liquidity swings.