How Likely is Another Flash Crash?


SAN DIEGO ( - I have good news and bad news. Here's the good news: The May 6th 'Flash Crash' that spooked global markets is over. Now for the bad news: It's exact causes still aren't known and could reoccur.

What was the 'Flash Crash' and how did it happen? And moreover, how likely is another similar episode in the future? Let's investigate together.

The Anatomy of an Epic Decline
The 'Flash Crash' on May 6th triggered a massive decline in stocks and sent shockwaves throughout global financial markets. The Dow Jones Industrial Average (NYSEArca: DIA), a barometer of 30 U.S. blue chip stocks, fell a record 998.5 points or 9.2% in value. Other leading market indexes like the S&P 500 (NYSEArca: SPY) and Nasdaq Composite (NasdaqGS: ONEQ) were also hammered. 

Among the most surprising aspects of the 'Flash Crash' was the suspicious trading activity of certain stocks. Procter and Gamble ( PG ) fell almost 37% before quickly rebounding. Other stocks like Accenture ( ACN ) and Exelon ( EXC ) briefly traded for cents.

And perhaps the most amazing part of the stock market's colossal decline on May 6th wasn't the $1 trillion that temporarily vanished, but its unprecedented immediately rebound. By the final 15 minutes of the trading session, stocks reversed their intraday losses. When, besides never, has this ever happened in stock market history?

Questions and Answers
There are various explanations of why the 'Flash Crash' occurred and virtually all of them are unsatisfactory. The Wall Street Journal suggested a large order of put options by a hedge fund might have been a factor. Another report claims a $4 billion trade of e-mini contracts on the Chicago Mercantile Exchange was at fault. Others blame an errant trade made by someone that pressed the wrong button their keyboard.

In Congressional testimony, S.E.C. Chairwoman Mary Schapiro said 'stub quotes' may have caused certain stocks to trade for 1 cent a share. 'The absurd result of valuable stocks being executed for a penny likely was attributable to the use of a practice called stub quoting,'' she stated. 'When a market order is submitted for a stock, if available liquidity has already been taken out, the market order will seek the next available liquidity, regardless of price. When a market maker's liquidity has been exhausted, or if it is unwilling to provide liquidity, it may at that time submit what is called a stub quote - for example, an offer to buy a given stock at a penny. A stub quote is essentially a place holder quote because that quote would never - it is thought - be reached.'

While Schapiro's explanation sounds intellectually smart, she never explained why the S.E.C. allowed harmful stub quotes to exist in the first place. Since then, the S.E.C. has moved to ban the practice.

Finding a Cure
Any honest doctor will openly admit it's difficult to cure a problem when you don't know its exact causes. In fact, prescribing medication without knowing the source of the patient's problem could endanger their life. None of this, of course, has stopped Wall Street's cop, the S.E.C., from prescribing a wide range of experimental solutions.

Better communication and oversight among the public exchanges that list securities and derivatives is being tried. 

Among the other fixes being tested are trading cubs also known as circuit breakers. The system acts as a sort of fire alarm that automatically halts trading for five minutes on any S&P 500 stock that rises or declines more than 10% within a five-minute period.

How well have the fire alarms been performing?

On June 2nd, the share price of Diebold ( DBD ) briefly fell 35% before circuit breakers went into effect. In other words, the problem of market crashes in both individual securities and broadly diversified benchmarks still hasn't been resolved.

Do you believe in tame lions and tigers? How about tame markets?

I don't.   

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.

This article appears in: Investing , ETFs

Referenced Stocks: ACN , DBD , EXC , PG



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