How to Avoid a Flash Crash

On May 6th 2010, the US equities markets were rocked by what has since become known as the “Flash Crash”. This was the day when the Dow Jones collapsed by 700 points in the space of a few minutes, only to rebound back close to previous levels shortly afterwards. It was a crazy half hour.

Since that day, many observers have pointed the finger of blame at the high frequency traders (high frequency trading is where complex computer models are used to send thousands of orders into the market at sub-second speeds, hoping to capitalise on arbitrage opportunities). But evidence points to the fact that when the markets started to collapse, the high frequency traders actually pulled out of the market and temporarily switched their systems off. Why did they do that? Simple. You might be the best high frequency trader in the world, but if markets are behaving completely unpredictably and going through such wild swings, the models quickly stop working.

So how could such a “flash crash” have been avoided? To answer this question, it’s probably a good idea to take a look at what the Nordic exchanges are doing. The Nasdaq OMX group of exchanges in Norway, Sweden, Denmark, Finland and Iceland are planning to introduce a new set of safety mechanisms designed to temporarily halt trading under certain high-volatility conditions. Effectively, what they are introducing is a set of circuit breakers.

This is a smart move. The growth of algorithmic trading and high freuqency trading has brought with it an increased danger of a “rogue algorithm” going haywire, sending thousands (or even millions) or spurious orders into the market and causing a complete meltdown. Intelligent use of circuit breakers will prevent this happening.

It remains to be seen how effective these “volatility guards” that are being introduced by Nasdaq OMX will actually be. But if the Nordic exchanges it right, and if the US exchanges continue to get it wrong, will we see a liquidity shift away from to the US towards Scandinavia? Will investors feel more comfortable doing business on exchanges where they know there is an increased level of safety against potential flash crashes in the future? Only time will tell.

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