An Extreme Version of a Routine Event

The flash crash of May 6 has generally been viewed as a pathological event, unprecedented in history and unlikely to be repeated in the foreseeable future. The initial response was to lay blame on an external source for the instability: fat fingers, computer glitches, market manipulation, and even sabotage were all contemplated. But once it became apparent that this was a fully endogenous event, arising from interactions among trading strategies, it was time to drag out the perennial metaphor of the perfect storm. Consider, for instance, the response from Barclays Capital:

Thursday’s market action, in our opinion, did not begin and end with trading errors and/or exchange technology failures. Nor, as some commentators are suggesting, were quantitative trading strategies primarily responsible for the events that unfolded. All of these forces may have contributed to the voracious sell-off, but our analysis suggests that last Thursday’s events were more a function of a “perfect storm,” to borrow a cliché phrase.

Resorting to this tired analogy is both intellectually lazy and dangerously misleading. It lulls one into a false complacency and suggests that there is little one can (or needs to) do to prevent a recurrence. And since the correction was quick, and trades at the most extreme prices were canceled, it could even be argued that little damage was done. Might this not reflect the resilience of markets rather than their vulnerability?

But consider, for a moment, the possibility that far from being a pathological event, the flash crash was simply a very extreme version of a relatively routine occurrence. It was extreme with respect the the scale of departures of prices from fundamentals, and the speed with which they arose and were corrected. But it was routine in the sense that such departures do arise from time to time, building cumulatively rather than suddenly, and lasting for months or years rather than minutes, with corrections that can be rapid or prolonged but almost impossible to time.

Viewed in this manner, the flash crash can provide us with insights into the more general dynamics of prices in speculative asset markets, in much the same manner as high speed photography can reveal intricate details about the flight of an insect. The crash revealed with incredible clarity how (as James Tobin observed a long time ago) markets can satisfy information arbitrage efficiency while failing to satisfy fundamental valuation efficiency. The collapse and recovery of prices could not have been predicted based on an analysis of any publicly available market data, at least not with respect to timing and scale. And yet prices reached levels (both high and low) that were staggering departures from fundamental values.

So what can we learn from the crash? The SEC report on the event contains two pieces of information that are revealing: the vast majority of trades against stub quotes of five cents or less were short sales, and there were major departures of prices from fundamentals in both directions, with a number of trades executed at ten million dollars per round lot. It is very unlikely that these orders came from retail investors; they were almost certainly generated by algorithms implementing strategies that involve directional bets for short holding periods in response to incoming market data.

While the algorithmic implementation of such strategies is a relatively recent development, the strategies themselves have been around for as long as securities markets have existed. They can be very effective when sufficiently rare, but become increasingly vulnerable to major losses as they become more widespread. Their success in stable markets leads to their proliferation, which in turn causes the information in market data to become progressively more garbled. These strategies can then become mutually amplifying, resulting in major departures of prices from fundamentals. When the inevitable correction arrives, some of them are wiped out, and market stability is restored for a while. This process of endogenous regime switching finds empirical expression in the clustering of volatility.

The reason why departures of prices from fundamentals were so quickly corrected during the flash crash was because the discrepancies were so obvious. It was common knowledge among market participants that a penny per share for Accenture or a hundred thousand for Sotheby's were not real prices (to use Jim Cramer's memorable expression) and therefore presented significant and immediate profit opportunities. Traders pounced and sanity was restored.

But when departures of prices from fundamentals arise on a more modest scale, a coordinated response is more difficult to accomplish. This is especially the case when securities become overvalued. Bubbles can continue to expand even as awareness of overvaluation spreads because short selling carries enormous downside risk and maintaining short positions in a rising market requires increasing amounts of capital to meet margin requirements. Many very sophisticated fund managers suffered heavy losses while attempting to time the collapse in technology stocks a decade ago. And many of those who recently used credit derivatives to bet on a collapse in housing prices might well have met the same fate were it not for the taxpayer funded rescue of a major counterparty.

Aside from scale and speed, one major difference between the flash crash and its more routine predecessors was the unprecedented cancellation of trades. As I have argued before, this was a mistake: losses from trading provide the only mechanism that currently keeps the proliferation of destabilizing strategies in check. The decision is not one that can now be reversed, but the SEC should at least make public the list of beneficiaries and the amounts by which their accounts were credited. Dissemination of these simple facts would help to identify the kinds of trading strategies that were implicated. And it is information to which the public is surely entitled.