The 2010 Flash Crash: What Caused It and How to Prevent the Next One

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Remember the flash crash? That was the 20 minutes on May 6, 2010 when the Dow lost almost 1,000 points before partially recovering. Most investors have forgotten about it. But not iShares, the Blackrock (BLK) subsidiary that accounts for 50% of trading in exchange-traded funds (ETFs). iShares' spokesperson Leland Clements told me on Wednesday afternoon that while his company doesn't know exactly what caused the flash crash, it has three proposals to keep it from happening again.

Three Possible Flash Crash Causes

I was amazed that Blackrock, which has a massive database of individual trades, was unable to pinpoint the cause of May's flash crash. But Clements said that iShares research reveals three likely culprits:
  • Fragmentation among stock exchanges. In 1987, when we had the crash that took 22.6% off the Dow, trading execution was much slower and more concentrated. Back then, 90% of stock trading occurred on the New York Stock Exchange (NYSE). In 2004, Regulation NMS changed all that -- encouraging the emergence of new electronic exchanges like BATS and DirectEdge. By 2010, a mere 15% to 17% of all NYSE trades were controlled by the NYSE (the new electronic exchanges controlled the rest).
  • Different ways of trading with exchanges that go into so-called slow mode. These new exchanges had different ways of handling big ups and downs in the market. The NYSE preserved a way to put people in charge -- and take control away from the computers -- in the event of a big percent change in a stock's price. Putting a person in charge of trading a stock was called slow-mode. Some of the new electronic exchanges had rules that caused them to stop trading with exchanges that went into slow mode. This led different exchanges to quote very different prices for a specific stock.
  • Inconsistent rules for handling bad price information. These different prices caused some market participants to lose confidence in the price information they were getting from the markets. And these participants' computers were programmed to shut down and stop trading in the event that they received bad or mis-information.
iShares believes that these factors, coupled with an already volatile market and concerns about Greece's financial stability, all contributed to the flash crash.

Benefits and Costs of Making Exchanges Competitive

What strikes me as most interesting about these findings is that they undermine a basic tenet of America's antitrust laws -- monopolies are bad and competition is good. While Reg NMS boosted competition among exchanges, that competition has had a mixed effect for consumers of those exchanges. It has lowered trading costs and accelerated trade execution down to a fraction of a second. But that competition has also traded off speed of execution for quality -- anyone who held Accenture (ACN) stock and watched it tumble from $40 to six cents during the flash crash would agree.

And then there's the problem I wrote about on DailyFinance in which some high frequency traders buy market trade data and use the location of their computers close to those of the exchange to place orders a fraction of a second before those market trades are about to be executed -- a form of trading in what I called insidery information.

How To Prevent the Next Flash Crash

So how does iShares suggest that the SEC change the so-called market structure to prevent the next flash crash? In general, it wants clear agreement on how different exchanges should work together when there's a market breakdown. Here are its three key proposals.
  • Agree on a standard definition of an erroneous trade. As noted above, not all participants agree on what constitutes an erroneous trade. Some would argue that if there is no demand for a stock at $40 and the only way to execute the sale is to cut the price to six cents, that's fine. Others would call that an erroneous trade. iShares believes that all exchanges must agree on a standard definition to stop the next flash crash. And they must then agree on how to cancel and communicate such an erroneous trade.
  • Create standard ways for exchanges to deal with an exchange that goes into slow mode. During the flash crash, some electronic exchanges refused to deal with an exchange that decided to go into slow mode. Instead, they went on to trade with other exchanges that continued to operate in regular mode. iShares believes that all exchanges need to have standard rules for ignoring what Clements called "a pool of liquidity," such as the NYSE or any other exchange that goes into slow mode.
  • Boost transparency of market makers' obligations and incentives. Finally,iShares wants the SEC to define the obligations of so-called Designated Market Makers (DMMs), such as the people on the NYSE who seek to create an orderly market in stocks like Accenture. Specifically, iShares wants to make it clear that DMMs have an obligation to keep a stock's price from collapsing and create incentives for them to step in and buy when there are no other buyers to keep the price from collapsing.
Clements said that iShares has been talking to many market participants about these proposals, and there seems to be general agreement about them. But he anticipates that different exchanges may resist changes that cut into profits.

In the meantime, the Securities and Exchange Commission is planning to pilot new market structure rules, see how well they work, and modify them based on the results of the pilot.

The hope is that any changes will preserve the benefits of competition while fixing the market's problems.
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