Yesterday's Cocoa Futures Flash Crash And The Dangers Of Electronic Trading

Yikes, since the May 6, 2010 Flash Crash, we have seen continuous mini flash crashes in all kinds of single stocks, and one foreign stock index(DAX).  

We have seen weird stuff in the futures markets too-flash rallies and crashes.  Yesterday, there was a flash crash in cocoa.

The cocoa market has been incredibly volatile this year.  A poor crop last year combined with political problems in the Ivory Coast have contributed to a rocky road for prices.  Still, a flash crash shouldn’t happen.  Technology was the culprit here, not traders or the market.

Cocoa is not a heavily traded commodity market like corn, S+P’s, or Treasuries.  It’s a small, but essential market.  All production has risk, and the cocoa futures market allows participants to hedge that risk, contributing to lower prices.

Exchanges need to re-engineer how technology interfaces with smaller and lightly traded markets.  Massive instantaneous moves give markets a black eye and drive participants to OTC markets.  Driving them to OTC markets makes it harder to ascertain the price, since large volumes of trade are not transparent.

The $ICE exchange cancelled all trades below $3,400 a ton.  This is not unprecedented, in all markets exchanges and pit committees cancel trades from time to time.

Traders also get hurt by these moves.  Suppose you didn’t have a position, bought the market on the break and sold it a few points later making a nice profit on a scalp. If you sold it above $3,400, you now have a short position with the market moving against you!

This is why the revelation that hackers got into the NASDAQ ($NDAQ) caused market participants to shudder.  What if a hacker intentionally gets into a market and screws it up?  They could cause dominoes to fall in the world economy.  I realise exchanges have staffs dedicated to prevention, but even the US military and intelligence agencies have seen systems compromised at times.

In the old open outcry trading days, it wouldn’t take that long to make a decision on cancelling trades.  In addition, it was very rare to have markets make gigantic moves where traders were caught short or long above or below the cancelled trades.  That really was a phenomena that only happened with the advent of electronic trading in 1997.

I want to be clear, I am not against electronic trading.  However, there has to be a higher standard of care when static machines are interacting with the market.  While electronic trading has gotten faster over the years, little has changed in the way we interface with the market.  It might be beneficial to slow it down, or at least rethink how we interface and execute in markets.

Exchange executives and boards hate paying the fixed costs of their trading floors.  They’d love to get rid of them.  However, it may be that the trading floor is the best place to create an efficient market-with a re-imagined way of technology interfacing with it.  The way the current system is working is hurting the market mechanism in the long run.

This post originally appeared at Points and Figures.

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