The history of 2010 Flash Crash

By Dongliang “Larry” Yi

Background

The 2010 Flash Crash was a US stock market crash, which started at 2:32 pm, May 6th EDT and lasted for approximately 36 minutes. The Dow Jones Industrial Average experienced its largest intraday point drop, plunging 998.5 points (about 9%) from the opening, most within minutes, only to recover a large part of the loss^[1]. Other stock indexes, such as S&P 500, Russell 3000 and Nasdaq Composite, also collapsed and rebounded very quickly. This market crash immediately caused trillion-dollar market loss, and recovered most of the value at the close. Some blue-chip stocks, like Procter & Gamble, traded as low as $0.01^[2], but closed at $60.75.   

Many Exchanged Traded Funds (ETFs) holding US stocks declined during the same time. However, as neither no-US markets nor fixed income trading experienced this price drop, ETFs holding US fixed income securities and non-US equities were not affected^[3].

Causes

On Sept. 30, 2010, a joint report issued by SEC and CFTC detailed how a large mutual fund firm (reportedly Waddell & Reed) selling an unusually large number of E-Mini S&P contracts first exhausted available buyers, and then high high-frequency traders (HFT) started aggressively selling, accelerating the effect of the mutual fund’s selling^[4].This “hot potato” trading generated lots of volume but little net buying, and contributed to the liquidity crises and sharp price declines that day.

       

Although HFT did not cause the flash crash, it contributed to extraordinary market volatility on May 6, 2010. HFTs use their technological advantage to aggressively affect the bid or ask price, and cause all other traders who are not fast enough to react to an imminent price move. At times of market stress and increased volatility, this trading activity may exacerbate a directional price move and contribute to volatility^[5].

A trader, named Navinder Singh Sarao was later accused by the US Department of Justice for this 2010 market crash. Sarao was said by using spoofing algorithms to place thousands of E-mini S&P 500 stock index future contracts which worth about $200 million. He modified commercially trading software, so he could rapidly place and cancel orders automatically which could affect stock price and was alleged market manipulation^[6].

Aftermath      

After 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^[5]. In response to public pressure, government regulators and self-regulatory organizations around the world have come up with a variety of anti-HFT measures like a tax on financial transactions designed to make HFT prohibitively expensive.

The SEC also got criticized for not keeping their paces with current development in the market. Analysts from Morningstar claimed that "ETFs are a ‘digital-age technology’ governed by ‘Depression-era legislation’."^[7] The events of May 6 have put more emphasis on improved regulation, and have highlighted the need for regulators, financial service providers and the exchanges to work together on market structure reforms^[3].

Reference:

[1] Kirilenko, Andrei; Kyle, Albert S.; Samadi, Mehrdad; Tuzun, Tugkan (May 5, 2014), The Flash Crash: The Impact of High Frequency Trading on an Electronic Market (PDF), retrieved 24 April 2015

[2] Bowley, Graham (Oct 1, 2010). "Lone $4.1 Billion Sale Led to 'Flash Crash' in May". The New York Times. Retrieved 28 October 2010.

[3] “Understanding the “Flash Crash”: What Happened, Why ETFs Were Affected, and How to Reduce the Risk of Another”. BLACKROCK. November, 2010

[4] “What caused the flash crash? One big, bad trade”. The Economists. Oct. 1st 2010

[5] Kirilenko, Andrei A., et al. "The flash crash: The impact of high frequency trading on an electronic market." Available at SSRN 1686004 (2015).

[6] Bates, John (April 24, 2015), "Post Flash Crash, Regulators Still Use Bicycles To Catch Ferraris: Blaming the Flash Crash on a UK man who lives with his parents is like blaming lightening for starting a fire", Traders Magazine Online News, retrievedApril 25, 2014

[7] "Should You Fear the ETF? ETFs are scaring regulators and investors: Here are the dangers—real and perceived". Wall Street Journal. Retrieved 7 December 2015.