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Flash Crash Lessons and Fixes May 31, 2010

Posted by federalist in Finance.
Tags: ,

In the aftermath of a crisis or accident crowds have an unfortunate tendency to build momentum behind overwrought and foolish responses. This is especially bad when the response is promulgated through government, which is ever capable of codifying bad ideas into law but only rarely manages to repeal them.

May 6 saw a “flash crash” in U.S. equity markets: a crisis that started sometime after 14:00 and was essentially over by the time the market closed at 16:00. It revealed a number of problems in the current market structure, and it also cost some market participants serious money. On May 6 we learned:

  1. Official market makers will not always make reasonable markets (see “stub quotes”)
  2. Beyond official market makers, there are significant liquidity providers who contribute to market efficiency but who can suddenly step away
  3. You should never blindly enter an order to trade without a limit price
  4. You should probably put limits on any standing stop orders, too
  5. At least one “sophisticated” market participant was using a poorly programmed algorithm (that would be the one that was sending orders to sell short stocks at a penny!)

These lessons were clear within a week of the flash crash. Yet in response the crowds seem to have concluded that the correct “fix” to these problems is to put “circuit breakers” on individual listings to halt trading on any stock that experiences a sudden change in price exceeding some threshold. This is a bad idea.

For one thing, stock-level circuit breakers could easily spark a contagion effect through the ETFs and index futures (which investors may use to protect themselves while a particularly large stock is halted). Furthermore, stock-level circuit breakers would actually tend to exacerbate volatility on stocks that begin to trade near any threshold that is set.

What’s the right response? Well, we do still need to look into whether market makers are fulfilling their obligations. But there’s a simple way to ensure that nobody will unwittingly lose money in a flash crash ever again: Require that all orders, at least from retail investors, include a limit price.



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