On May 6, 2010, stock markets plummeted instantaneously and miraculously rebounded just minutes later in what was dubbed “The Flash Crash.”There were many factors that led to the Flash Crash, as explained by The New York Fed.
- Volatility in the markets – On May 6, volatility was rather high in the US markets. An abnormally large automated sell order was initiated on the S&P E-mini market, which is a futures market, that was executed extremely quickly despite the fact that an order of its size was not normal executed at one time.
- High Frequency Traders (HFTs) – An HFT is a trader that uses sophisticated algorithms to make securities trades. The large sell order on the S&P E-mini market caused selling pressure that was absorbed by HFTs moreso than any other market participant. The algorithms set up by HFTs forced selling once big drop offs were expected, and they did just that after the order was made. A study by Andrei Kirilenko stated that HFTs did not cause the crash, but their response to the selling pressures increased volatility even further and led to the crash being more severe.
- Withdraw of liquidity providers – Along with HFTs, traditional market makers exited from equity markets and ETFs due to the sell off. Liquidity then dropped and prices swung significantly. Order flow toxicity, which is the buy and sell orders arriving in the market, occurred when the liquidity providers left the market rapidly.
- Intermarket Sweep Orders – An ISO sweeps several different market centres and scoops up as many shares possible from them all. A study by Sugato Chakravarty of Purdue University states that ISO trades were used significantly more in the 30 minute period leading up to the crash.
- Market Fragmentation – Since there are a plethora of platforms to which trading activity occurs, market fragmentation partially led to the high volatility in the market. Since trading activity is fragmented across different venues, the depth of the market in each venue is relatively low. An index that monitors market fragmentation was higher on May 6 than in the previous 20 days of trading.
These factors came together as an essential “perfect storm” to create the Flash Crash. The changes that have occurred since the Flash Crash to prevent another similar event revolve mostly around regulations and the adoption of circuit-breakers. A circuit-breaker is a point at which a market will halt trading for a period of time after excessive drops in value. The adoption of these regulations should lower the chance of a Flash Crash occurring again, but there is certainly no guarantee that these new rules will prevent it from ever happening again.
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