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Flash Crash in Trading Markets

A term that is known to few and understood by even less. So, what is a flash crash? Why does it happen? How can it be prevented?

What is the flash crash?

A flash crash is an event in the electronic securities market wherein withdrawal of stock orders rapidly amplifies the price declines and then quickly recovers. The result appears to be rapid sell-offs of the securities that can happen over a few minutes, resulting in dramatic declines. However, usually by the end of the trading day prices rebound like it never happened.

Important points remember :

  • A flash crash refers to a rapid decline in stock price or market due to withdrawal of order which is quickly recovered usually in the same trading day

  • High-frequency traders or trading institutes are largely responsible for flash crashes

What causes a flash crash?

A Flash crash is triggered due to human error

A flash crash that occurred on October 12, 2012, in National Stock Exchange India (NSE) was due to Emkey Global House Financial Services. When one of their traders wrongly entered a huge amount on behalf of their institutional client which led to a fall of 900 points in the market within just a few minutes. As per NSE’s statements, algorithmic trading was not the reason for this crash but most of the time algorithmic and high-frequency trading escalate such scenarios.

Flash crash also happens solely due to algorithmic & high-frequency trading.

A flash crash, like the one that occurred on May 6, 2010, got exacerbated as computer trading programs react to the aberrations in the market, which lead to heavy selling in one or many securities, and automatically selling was undertaken in large volumes at an incredibly rapid pace to avoid losses.

As the securities trading market has become a largely computerized industry that is driven by complicated algorithms across global networks, the propensity for glitches, errors, and even flash crashes has also risen.

What can be done to prevent it from happening in the future?

Flash crashes are a phenomenon that is not fully understood. While a human error can create the required spark, computerized systems can ignite flash crashes. One of the characteristics of a flash crash is that there is a sharp price movement when there is no fundamental reason for such extreme volatility. Plus, the near-light speed at which they can happen with the subsequent recovery is driven by high-frequency traders using algorithms.

It also seems clear that the lack of human participation, when major markets are closed and liquidity is low, increases the role of algorithmic traders. The fact that most of these computers trade with one another (and themselves) means one fat finger or an incorrect bit of programming of one algorithm often triggers another algorithm, which triggers another, and so on.

But the lack of true understanding about flash crashes means we are far from finding a solution that eradicates them, demonstrated by the fact they keep happening regardless of what measures have been introduced by exchanges and others.

Still, exchanges and regulators have taken many steps to prevent them from happening or at least minimize the damage created by them.

  1. The first step to prevent the crashes was circuit breaker on individual securities as well as a single circuit breaker on the whole market when there is a fall (ideally 10%) more than a specific amount depending upon the regulators of the specific market.

  2. Large Trade reporting: The dominant players of the market measured by the volume will now have a special identifier and be required by the regulators to give more information.

  3. A ban on “stub “quotes.

  4. Tighter rules for market makers: As a part of stub quote ban, registered market makers must submit the quotes no more than 8 percent (depending on regulators) away from best bid or ask for the stocks under the circuit breaker and not more than 30 percent (again depends on regulators) away from other securities.

  5. A ban on “naked” access to markets: Brokerages are no longer permitted to provide high-frequency traders unfettered, or “naked,” access to the marketplace, instead, they are required to monitor traders’ activity for erroneous or other potentially damaging orders.

  6. Clarifying “clearly erroneous” trades: A standard definition of trades that exchanges will cancel if executed, based on how far they are away from the public stock price. This gives investors the clarity they didn’t have immediately after the crash.

NOTE : Measures mentioned above are in the context of the 2010 crash and the steps taken by the SEC to prevent them from happening in the future. Different regulators have adopted different measures to prevent it from happening in the future.

“Why is panic in the stock market newsworthy? That's all they ever do! It must be easy to get hired as a stockbroker: 'Show me your panic face! You're hired!!”
― Stewart Stafford

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