AIM 71.1:Describe the chronology of the Flash Crash and the possible triggers for thiseventdiscussedin recent research.
May6, 2010,hassecuredaprominent placeondiepagesof thehistorybooksof die U.S. equity markets forthemostsevereintraday turbulenceand chaotic priceswingsever exhibited. The DowJones IndustrialAverage (DJIA)declinednearly 1,000 points in five
minutes (2:42-2:47pm)andregained600 pointswithin another20minutes—thebiggest
intradaydecline and die secondlargest total pointswingin DJIAhistory.
May6, 2010,is remembered bymany names,includingthe “2010FlashCrash" or‘'May 6thFlash Crash.11 The marketopened amidst theworriesofa European sovereign debtcrisis andexhibited turbulent volatilityandliquidity.Against thisbackground,at 2:32 pm,a
largefundamental traderconcernedwith thepotentialdecline inthe equity positionplaced
asell order of75,000E-mini S&P500 futurescontracts,valuedatnearly $4.1 billion.
The trader used theprogram trading (algorithm) toexecute diishedgingstrategy, targeting
anexecution rateofacertain percentageof previousminute transacted volume withno
considerationoftime or price. Within minutes of theexecutionof this unusually large trade,high frequencytraders also started sellingtheirlongfutures positions. Thenext buyer alsoquicklysold the position.Thissellingandbuying,andbuyingandselling,increased the volume and exerted continuingdownwardpressureon theE-minifuturescontracts.
Thefuturescontractslost 3% invalue hetween 2:4l and2:44pin.At thesame time,the
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arbitrageurswhohoLightdielong posilion ofS&P 500 futuresstarted,sellingtheS&P500 exchange tradedequity index(ETF)forhedgingpurposes.TheS&P500ETFalsolost 3% ofitsvaluein minutes.Facing increasinglyerraticand hugepriceandvolumespillover fromfutures toequity market, manyhigh-frequencytraders (HFTs) quit the equity market, furthersqueezingtheliquidity.Internalizes,in turn,startedroutingthe sellordersco the puhlicequitymarkets,puttingfurdier downward pressureonprices.Other tradersand firms also intensified theirsellingeffortsin thisenvironmentofdwindling liquidity and decliningprices, producingdie crash of May6,2010—a9%(nearly1,000 points) decline within fiveminutes.
Ac2:45pm, theChicagoMercantileExchange(CME) paused thetradingin S&P
futurescontractsfor afewseconds,givinganopportunitytothe HFTs and other market participants to re-evaluateandrethink theoverall market condition andexamine their tradingstrategiesand datasystems.When the tradingre-opened,the buyinterestemerged, sellingpressurewentdown, and pricesinbothfuturesandthe equity market tookan
upward move.Within minutes,die prices beganstabilizingand reflectingfundamental consensusvalues,puttingthe FlashCrash onthepagesofhistory,allowing academicians and practitionerstoevaluateits causesandeffectsandfind possible solutionsfordealing
withfuture potentialcrashes.
Possihle Trigger1:InitialTheories
Immediatelyafter thecrash,manyspeculativetheorieswereextended to identifythecauses ofthecrash.Forexample,atrader enteredanorder incorrecdy,amajor trading market venueexperiencedasoftwareglitch,and last butnot least,therewasawell-plannedand well-executed conspiracytoseverelydamagetheU.S.financialsystem.
Possible Trigger 2:Exchange-Traded Portfolios (ETPs)
ProfessorsNote:ETPsincludeexchange-traded funds(ETFs), exchange-traded
notes(ETNs), and leveragedETFs. ETPscontributenearly40% ofthe volumeto
overalltradingin the UnitedStates.
4ÿÿ
Given the severeimpact onETPs during the FlashCrash,somebelieve thar theETPswere
culprits* AccordingtotheETPs’critics, thepricing,structure,and tradingofETPswerea major source ofdisruption inthe market activity of May6,2010. Someempiricalstudies concluded that dievolatility spilloverfromfutures toequity marketsduringthe Flash Crash washeavilycausedbyETPs.Otherstudiesarrivedatsimilarconclusions,suggestingdiat die ETPs* pricingmechanism [i.e*,theremaybedisparitybetween the priceofanETPand underlyingnet assetvalue(NAV)J and therapid proliferationofETPs producedasystemic risk tothe financialsystem.It's possiblethat ETPs couldgeneratemuch more severecrashes in thefuture.
Possible Trigger3:High-Frequency Trading(HFT)
High-frequency tradingrefers torouting oforderstomarket places that offerminimum
possible reaction time(i.e., themaximum possiblelast response).HFTisexhibitinga
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significantupward trendand,accordingtosomeempiricalestimates, itaccountsfor nearly 70% of dollar trading volumein U,$*equity markets*
High-frequency tradersareknown for usingquotestuffingtacticstogaina competitive edgeover others.They post aquoteand then immediatelycancel it*According toone
estimate,ordercancellation isin the range of 90%.The purpose of bombardingthemarket withquotesistokeep the other traders,includingthe less thansophisticatedtrader,busy analyzingandcomputingdie dataso theymay donothing but handle the raw quote traffic.
During thismassivequotestuffingperiod,fewer tradestakeplaceand the HFTsare the beneficiariesof such trades.Inalowquotestuffingperiod, ahighnumberof tradesare executed,but the HFTsare usuallyoutof thetradingactivity (becausesucbtradesarefor lesssophisticatedinvestors)*Sodiequotestuffingcreatesa two-tier market—onefor HFTs
and the otherfor lesssophisticatedinvestors.Within thefamilyof HFTs,thewinners are theoneswho havemoresophisticated computationaland networksystems.Also, itshould be noted thatquotestuffingactivityhasapparendynolinkagetotradingvolume or market events.
Empiricalstudiesoffer different resultsonHFTanditsimpacton marketquality.Onone hand,studiesshow thatintensequotestuffingisassociatedwith increasedvolatility,lower liquidity,higher transaction costs,and impairment of pricediscovery.On dieodierhand, somestudies show that HFT reducesvolatility,narrowsspread*s,increasesdepLh (of the market), and reducesadverseselection. Otherstudiesshowmixedresults*Onestudyfound thatHFTgeneratesefficient pricingbutat thecostofawidening spread.Anotherstudy
setsHFT free from theallegationofheingatriggeringcause of the Flash Crashbutholdsit responsibleforcontributingto the declineinmarket liquidity.
Possible Trigger 4:ToxicOrders and Intermarket Sweep Orders(ISOs)
Orderflow(or venue trading), toxicity, andaggressiveorder behaviorcan disrupt liquidity, causingdestabilizationin die market. OrderHowtoxicityisassociated withan increase in probabilitythatinformedinvestors(hedgefunds) adverselyselecttheuninformedinvestors
(market makers).Marketmakersareforcedoutof themarket,liquiditysqueezes,andthe order flow becomes moretoxic.Thefeedback loop continually putsdownward pressureon
liquidity.Anempirical studyfindsstrongevidenceofan increase in toxicorder flowanda resulting declineinmarket liquidity(one hour) before the Flash Crash.
Intermarket Sweep Orders(ISOs), also knownasliquidity-demandingorders,are usedby aggressiveHFTs tosweepdieentire book,takingaway liquidity.An empirical studyfounda significantincrease in ISOsandthetakingawayofliquidityfrom thebid .sideof the market during the Flash Crash period,concludingthatISOsmay have been the triggeringcause of the FlashCrash,
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