Taking stock of flash crashes

By Robert Adler

Fancy a beer company with your pint? For a few painful minutes, the value of many major US companies hit zero. And computers may share the blame.

17 May 2010

On Thursday 6 May, for a few minutes, you could have bought a frothy Sam Adams plus a substantial interest in its maker, the Boston Beer Company, all for the price of a pint. Boston Beer stock, along with dozens of others on the major US stock exchanges, plummeted to zero, while the Dow Jones Industrial Average nosedived 700 points, all in a matter of minutes.

To the great relief of most traders and to anyone whose financial well-being is linked even indirectly to the stock market — and in today's global economy that's pretty much all of us — the market rebounded almost as quickly. Still, the wild ride left even seasoned traders in shock.

It's hard to overstate how much value was at risk during this ten-minute event.  As just one example, Exelon, a utility worth about $30 billion at 2.49pm  was worth nothing three minutes later. It's estimated that one trillion dollars of value evaporated during the ‘flash crash'. That's three times what the US spends on public education per year, $300 billion more the US  government bailout of the banking system in 2008, and about equal to the current European package to rescue Greece.

The grab-your-airsick-bag crash and rebound was certainly an anomaly, but that's not the same as saying that it was an error, in the sense that it was caused by some specific mistake or malfunction.

Economist and market analyst John Hussman points out that US stock markets have hit similar “air pockets” — in 1955, 1987 and 1999. Like the Thursday event, those episodes resulted in roughly ten percent losses. The big difference is that they played out over weeks rather than minutes.

Since the Thursday debacle there's been no shortage of finger pointing.

Early speculation centered on a so-called “fat-fingered trade” as the trigger for the selloff. Instead of offering to sell a few million shares of Procter and Gamble, rumour had it that a trader mistakenly put up a few billion shares.  Lacking buyers, the stock tumbled, starting a panic that took the rest of the market down with it.

The theory got a lot of attention, but like the infamous weapons of mass destruction in Iraq, there's no evidence for it.

The most recent theory is that as the market edged lower, a particular hedge fund placed a $7.5 million bet that the drop-off would continue, and the rest of the hedge funds followed suit. Do lemmings come to mind?

One suspect that most market gurus do agree on is high frequency trading.  Multiple firms now trade using high speed computers linked directly to the stock exchanges. These constantly analyse massive amounts of data and exploit fleeting opportunities by buying and sell huge quantities of stocks in milliseconds. Experts estimate that these automated agents now make from 60%-70% of all trades on US markets.

The dominance of these computerised agents goes a long way towards explaining what happened, and the absence of an identifiable trigger.

If there's one thing we've learned about complex systems since chaos theory pioneer Edward Lorenz popularised the idea of the ‘butterfly effect' in the 1960s, it's that they are capable of amplifying the tiniest perturbation to virtually any scale. It takes just one last snowflake to unleash an avalanche.

The stock market is a classic example of a highly dynamic system driven by many independent but interacting agents. One state it's capable of occupying— what system theorists call an attractor — is when the tug of war between buyers and sellers arrives efficiently at a stock's current value. That's the state that economists tell us is the market's  raison d'etre.

It would be lovely if that were the only way the system functioned. Unfortunately, history shows that stock markets are also prone to huge bubbles, in which contagious enthusiasm drives the prices of most stocks well above their “true” value, and, as we've just seen, “air pockets”, in which contagious fear does the opposite.

This was bad enough when human traders were the ones calling the shots. Presumably they had some sense that a company valued at $30 billion one minute couldn't really be worth zero a few minutes later. Their interaction led to booms and busts, but at least those had believable tops and bottoms and unfolded on a human time scale.

Over the years, the markets have instituted various fixes to try to avoid some of their worst flaws. After the global “Black Friday” market crash of 1987, the New York Stock Exchange, for example, put in place “circuit breakers” — trading curbs aimed at slowing panic selling in order to head off the kind of crash that we just saw.

Some market analysts are blaming the circuit breakers themselves for the Thursday meltdown. They suspect that when the NYSE circuit breakers clicked in, the effect was to shunt the flood of sell orders to other markets that were even less able to find buyers for them.

This circuit-breaker issue has gained traction. Six major exchanges have now agreed to strengthen and coordinate their circuit breakers. New rules are currently being negotiated and should be in place within a few weeks.

Those fixes may be good ideas, but they almost certainly are nothing but temporary patches. The system remains as complex, dynamic, and unpredictable as ever. It's still shuttling hundreds of billions of dollars form buyers to sellers at inhuman speeds every day, impelled not just by humans vacillating between greed and fear, but increasingly by bloodless computerised agents impelled by abstruse algorithms.

It's worth noting that there's no “beta testing” for these patches. That makes us guinea pigs in a very high-stakes experiment.

Regulators and investors would like to believe that the proposed fixes will result in an efficient, reasonably stable market. I think it's more realistic to view the market as something like a manic-depressive chef on speed— often brilliant, but capable of cooking up a disaster at any time.

Neither the recent high-speed collapse and rebound nor the current fix-it-on-the-fly patches inspire a great deal of confidence in the US stock market. Unfortunately, in this highly linked global era, we're all flying on the same airplane. I suggest that we fasten our seatbelts and brace ourselves for a wild ride.

Published with the author's permission. ©Robert Adler. All rights reserved.