The evolution of the financial markets has created an assortment of new questions and challenges for participants. While the core business of an active trader is to buy and sell securities, in recent years the issue of systemic risk has come to the forefront. Whether in the trade of currencies, futures or equities, dramatic volatilities often appear out of nowhere.
In the world's capital markets, volatility plays an ever-present role in the dynamics of every publicly traded product. Occasionally, regular pricing fluctuations give way to a sudden directional move to the downside.
A flash crash is an exceptionally swift decline in the pricing of a security traded on the open market. Flash crashes occur on compressed time frames measured in minutes or seconds and are typically followed by a rebound in price. Instances of this phenomenon have been observed in the markets of stocks, futures, currencies and cryptocurrencies.
Flash Crash: Root Causes And Drivers
The topic of flash crashes is controversial. Many in the financial community view them as being a form of artificial market manipulation. Others contend that the extreme price action is a natural product of the electronic marketplace as a whole. An alternative perspective assumes flash crashes to be the result of multiple inputs and an unavoidable statistical outlier.
No matter one's outlook, several contributing factors are accepted by the consensus as playing an important role in past flash crashes:
- Human Error: The United States Securities Exchange Commission (SEC) has cited human error as being a driver of periodic crashes in individual securities or markets. Instances of traders adding an extra zero(s) to an order or fund managers accidentally requesting large block orders be executed instantly at market have been deemed culprits of various flash crash incidents.
- Computer/Software Glitches: Discrepancies in data originating at the market or exchange have been found as the reason behind inaccurate pricing data associated with flash crashes. In addition, errors in the programming code of automated trading systems have had unintended negative consequences.
- Fraud: A practice known as "spoofing" involves placing large block sell orders at market only to be cancelled when price draws near. The U.S. Commodities and Futures Exchange Commission (CFTC) deemed this method the driver of a 2010 crash in the S&P 500.
- High-Frequency Trading (HFT): HFT is a controversial discipline where automated systems driven by algorithms are used to recognise changing market conditions and execute trades accordingly. HFT systems are able to place enormous numbers of orders upon the market at near-light speeds, thus magnifying the intensity of a negative move in pricing. While the role HFT firms play in the markets is disputed, central banking authorities such as Germany's Bundesbank believe HFT firms heighten the risk of flash occurrences.
The capital markets are complex venues, encompassing the activities of participants the world over. This fact makes determining a specific root cause of flash crashes problematic. Each crash is unique and is also the outcome of any number of isolated or contributing factors.
Flash Crash: Examples
Perhaps the most unique characteristic of flash crashes is that they are present across a wide-range of markets and products. Instances have been recorded in nearly every market including those of currencies, equities, futures and cryptocurrencies.
Below are few examples of prominent flash crashes:
- Forex: On 25 December 2017, the EUR/USD dropped by 3% in mere minutes before posting a quick rebound. The move was blamed on algorithmic trading systems as there were no economic events or market fundamentals responsible for the selloff during the holiday session.
- Stocks: One of the most famous flash crashes in the past decade took place on 6 May 2010. The crash featured a 10% drop in value of the U.S. equities indices over the course of several minutes. An SEC investigation assigned blame to a large sell order for E-mini S&P 500 futures contracts being executed extremely rapidly.
- Futures: Precious metals markets were rattled by a plunge in the value of silver futures on 6 July 2017. September silver futures fell by 11% in the minutes following a bulk execution of automated sell orders. Price regained a majority of the loss in the following hours.
- Cryptocurrency: In an extremely bearish run in price, Ethereum (ETH) lost nearly 100% of its marketshare in seconds. On 21 June 2017, ETH experienced an exchange-specific crash that took price from £226.50 to £0.07. No specific reason was given for the sudden plunge. Position liquidations due to the violation of margin requirements and an abundance of resting stop loss orders being triggered were the deemed culprits. Price returned to pre-crash levels in short order.
In the above cases, a variety of determinants have received the blame for the negative price action typical of a flash crash. While the primary reason(s) behind the events remain debatable, market liquidity concerns are cited as a constant theme in each occurence.
As a general rule, markets are not fond of uncertainty. Flash crashes bring anxiety to traders and investors in droves and have prompted extensive regulatory intervention. In an attempt to preserve confidence and integrity in the U.S. equities markets, the SEC has implemented an aggressive use of "circuit breakers" to reduce the severity of sudden crashes in single stock and index values.
Although such devices have been around for decades, they are now present in nearly every global financial venue. Trading halts and upper/lower pricing limits frequently accompany circuit breakers as safeguards in markets and exchanges around the world.
As technology moves forward, the risk posed to traders by sudden and unexpected volatility will remain palpable. However, given the increased security measures and participant education, negative effects of flash crashes may be greatly mitigated.
Senior Market Specialist
Russell Shor (MSTA, CFTe, MFTA) is a Senior Market Specialist at FXCM. He joined the firm in October 2017 and has an Honours Degree in Economics from the University of South Africa and holds the coveted Certified Financial Technician and Master of Financial Technical Analysis qualifications from the International Federation…