Return of the Flash Crash

Did you see the 60 Minutes expos on speed trading? I've embedded the video, which explains how high-frequency trading works. It sheds light on the May 6 flash crash—why the Dow dropped nearly 700 points in twenty minutes.

 

It's only a matter of time before we experience another flash crash. Here's why:

  1. High frequency trades comprise as much as 70 percent of all US stock trades.
  2. Computer programmers understand little about the securities their high-speed firms trade.
  3. They're programing "game play," where hedge funds win by processing information faster than their competitors.
  4. Because high-speed funds are competing with unique coding, the interplay of different algorithmscan lead to unanticipated consequencesas we saw on May 6.
  5. The NYSE is enabling this behavior, by encouraging high-speed traders to locate their computers in its facilities. More revenues for the NYSE and more speed for the traders.

What about the circuit breakers enacted by the SEC on September 10, 2010?

Trading in a security included in the program is paused for a five-minute period if the security experiences a 10 percent price change over the preceding five minutes. The pause gives the markets an opportunity to attract new trading interest in an affected stock, establish a reasonable market price, and resume trading in a fair and orderly fashion. The circuit breaker program is in effect on a pilot basis through Dec. 10, 2010.

Financial reform cannot keep pace with the markets or technology.

Hat tip to Tyler Durden at Zero Hedge—he blogged about several individual flash crashes that have occurred since the SEC's September 10 announcement.Plantronics, for example, fell from $31 to $24 over a "few milliseconds." One reason is that the circuit breakers apply to only Russell 1000 stocks. Plantronics is too small to qualify. It's in the Russell 2000. Even if Plantronics were in the Russell 1000, however, I doubt it would make a difference.

Trading is so fast that damage can be done before circuit breakers kick in.

Plantronics dropped about 22 percent in less than a second. What can happen over five minutes? Speed traders measure results based on milliseconds. Who's to say whether all their technology and algorithms play nice together?There may be an even bigger problem out there. Next time, I'll examine the following question:

What happens when transparency exacerbates a market problem?

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