Are we heading for a flash crash?

Dodgy dealing: Shia LaBeouf as a young trader in Wall Street: Money Never Sleeps, Oliver Stone’s 2010 sequel to the film that gave us Gordon Gekko in 1987

John Lanchester

10 April 2012

On May 6 2010, out of a clear blue sky, the US stock market suddenly dropped by 10 per cent. A trillion dollars was wiped off the value of US equities. The precipitate dive took place over 20 minutes, an astonishingly brief time span which earned it the name "flash crash". Over the next few hours, stock prices gradually recovered, making it clear that there was no real systemic crash, and leaving investors with one simple question: "What the hell was that?"

When things like this happen, the first scapegoat is the "fat finger". Fat finger mistakes are caused by traders making keyboard entry errors in the quantities or prices of stock they are trying to trade. The commonest is putting the decimal point in the wrong place. These boo-boos come along at fairly regular intervals. My personal favourite was in 2001: a trader at UBS Warburg who meant to sell 16 shares of a company at 600,000 yen, and ended up selling 610,000 shares at 6 yen. Doh! Cost of mistake: about $100 million. Difficulty of explaining what had happened to boss: considerable. But these mistakes can usually be absorbed pretty quickly by the market, since it is clear after some scrutiny that the underlying trade makes no sense at all — so there is no real issue for the investment community to worry about.

There is, however, a second potential scapegoat for a sudden market movement like the flash crash. The biggest one-day stock market crash in history was caused not by people but by computers. It happened on October 19, 1987, a day which became known as "Black Monday", and was the direct result of an innovation in the stock market. The new thing was "portfolio insurance" — a way of automatically setting a selling price for a basket of stocks. If the stocks fell below that price, the computer monitoring the portfolio would execute a sell order, and the investor's loss would be limited. It was supposed to be a foolproof way of protecting people's money.

On Black Monday, however, the markets had gone into the weekend feeling a little twitchy, and a backlog of sell orders had built up. When those orders were executed first thing on the Monday morning, prices started to drop, and then the portfolio insurance kicked in. The trouble is that all the computers involved were using broadly similar mathematical algorithms — so they all started to do the same thing at the same time. What in theory should have been an orderly, safety-first sell-off instead became a stampede for the exit. The computers were all selling into a market with no buyers — and that is a recipe for prices to freefall. In the event they lost 22.6 per cent of their value in one day, much worse than any equivalent period since the great crash of 1929.

One of the morals of the Black Monday story is that computer trading has big risks. Unfortunately, because there have been no equivalent computer-induced spasms inside the big exchanges since, complacency has built up. But conditions are changing in a way that makes another computer meltdown more likely. It was this possibility that caused markets to be so spooked by the flash crash this year: the phenomenon looked like the forewarning of a disaster which is beginning to seem thinkable.

The phenomenon responsible for the new uncertainty is high frequency trading. This is a technique used by the big boys: investment banks, hedge funds and large institutional investors.

The trading platforms involved use extraordinary computer power and super-sophisticated computer algorithms. If Gordon Gekko were to make a list of all the new things that had happened in the stock market since he came out of jail, high frequency trading would be right at the top.

The computers are sited as close to the stock exchanges as possible, and use the fastest data connections that money can buy. All this is to gain an advantage of thousandths of a second.

The computers analyse the flow of data through the market and study patterns of movements in stocks. They predict not where the market is moving next year, next week or tomorrow. They predict where the market is moving in the next 0.001 of a second, and in that time can execute both a buy and then a sell order to make a guaranteed profit.

They do this by manipulating the "bid-ask" spread — the gap between the price at which a stock is bought from and sold to the public. From the institution's point of view, the profit is risk-free.

Flash trading, as it is known, is a subset of this high frequency trading. In flash trading, a financial institution can peer directly into the flow of orders running through an exchange. Again, the units of time are thousandths of a second. In that time a computer can execute buy and sell orders to profit from the patterns it finds. Defenders of flash trading — which many exchanges don't permit—say that it increases the liquidity of shares and makes it easier, and cheaper, to buy and sell them. Critics point to the unfairness of the practice, which creates an obvious bias against the smaller investors whose trades are being anticipated and profited from. There are proposals to ban it, which haven't yet translated into action.

These might sound like esoteric details of the stock market. If only that were true. High frequency trading is huge. In the US, 60 per cent of all activity in the equity markets is high frequency trading. That's astonishing: it means that in just a few years, this new technique has grown to comprise the majority of all activity in the stock market. The apparent volume of listed trade is deeply misleading, since most of it is stock bought and sold between computers, with no human activity involved. In the UK we haven't gone quite as far down that route, but the London Stock Exchange thinks that high frequency trading represents more than 25 per cent of its activity.

It seems unfair to have to contemplate the prospect of another spasm inside the global financial system at a moment when we're only just beginning to work through the consequences of the last one. But we need to take May's flash crash as a warning.

On Friday, the US authorities published a report which explained what had happened. A single order, placed by a single firm, the US money manager Waddell & Reed, caused the $1 trillion crash. The order called for the sale of $4.1 billion of a type of futures contract called an E-mini, linked to the main American stock index, the S&P 500. Nothing unusual about that, except that, for reasons nobody knows, the order was set to be executed as quickly as possible and at any price possible. It went through in 20 minutes — and that's what sparked the crash. The speed of the sale caused the system to go into convulsion, and magnified the depth of the drop. The answer to the question, "What the hell was that?" was as follows: a medium-sized sale by a medium-sized money manager in Kansas City. That's what caused a market-wide spasm and temporarily cost a trillion dollars.

What the flash crash did was expose the vulnerability of a system which is now underpinned by high frequency trading. When such a huge volume of stock is being traded in microseconds with no human thought or supervision involved, well, it isn't hard to see the potential risks. And there are large questions about the basic fairness of the activity, too.

Why should small investors take part in the market if all they're doing is providing large institutions with the opportunity of making a guaranteed profit off their backs?

"When people ask me advice about the stock market," a lifelong equity investor told me, "I tell them not to bother — and the reason for that is flash trading."

That sentiment is catching on. Since the flash crash and the revelation about the scale of automatic trading in the US, small-investor participation in the stock market is sharply down, even as stock prices have risen.

The big institutions love high frequency trading because they make so much risk-free money out of it. The big boys will tell you that the upside of high frequency trading is that it helps liquidity — which is a good answer, since, as the credit crunch taught us, liquidity is the oxygen of the financial system.

But history may well show that the little people were right to be nervous. Even Gordon Gekko might be. Equity markets are now bigger than ever, are more automated than ever, and act almost unimaginably faster than human thought. What could possibly go wrong?

Are we heading for a flash crash?

Read More