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Flash Crash - May 6, 2010

The events of May 6, 2010 became known as the Flash Crash. High Frequency Traders (HFTs) did not cause the Flash Crash, but contributed to it by demanding immediacy ahead of other market participants. Immediacy absorption activity of HFTs results in price adjustments that are costly to all slower traders, including the traditional market makers.

Even a small cost of maintaining continuous market presence makes market makers adjust their inventory holdings to levels that can be too low to offset temporary liquidity imbalances. A large enough sell order can lead to a liquidity-based crash accompanied by high trading volume and large price volatility – which is what occurred in the E-mini S&P 500 stock index futures contract on May 6, 2010, and then quickly spread to other markets.

On May 6, 2010, in the course of about 36 minutes starting at 2:32pm ET, U.S. financial markets experienced one of the most turbulent periods in their history. Broad stock market indices the S&P 500, the Nasdaq 100, and the Russell 2000 collapsed and rebounded with extraordinary velocity. The Dow Jones Industrial Average (DJIA) experienced the biggest intraday point decline in its entire history. Stock index futures, options, and exchange-traded funds, as well as individual stocks experienced extraordinary price volatility often accompanied by spikes in trading volume.

In the aftermath of the Flash Crash, the media became particularly fascinated with the secretive blend of high-powered technology and hyperactive market activity known as high frequency trading (HFT). To many investors and market commentators, high frequency trading has become the root cause of the unfairness and fragility of automated markets.

In response to public pressure, government regulators and self-regulatory organizations (e.g., securities and derivatives exchanges) around the world have come up with a variety of anti-HFT measures. These measures range from a tax on financial transactions designed to make HFT prohibitively expensive and contribute to public revenue to “throttles” on the number of messages a trader is allowed to send.

Under calm market conditions, this trading activity somewhat accelerates price changes and adds to trading volume but does not result in a directional price move. However, at times of market stress and elevated volatility, when prices are moving directionally due to an order flow imbalance, this trading activity can exacerbate a directional price move and contribute to volatility.

Higher volatility further increases the speed at which the best bid and offer queues get depleted, which makes HFTs act faster, leading to a spike in trading volume and setting the stage for a flash-crash-type event. On May 6, HFTs exacerbated the Flash Crash by aggressively removing the last few contracts at best bids and demanding additional depth while liquidating inventories during key moments of dwindling market liquidity.

Flash-crash-type events temporarily shake the confidence of some market participants but probably have little impact on the ability of financial markets to allocate resources and risks. These events though raise a broader set of questions about the optimal market structure of automated markets.