Flash Crash Surprise, Five Years Later

It’s been almost five years since the ‘flash crash,’ when markets fell by about nine percent in less than 40 minutes in the middle of a trading day.

Some well-established companies like Procter & Gamble fell by 40 percent within one minute while others like Sam Adams traded for just one penny per share even though it was selling for around $60 per share minutes earlier.

I remember it vividly – I had just come out of a meeting and was heading back to my desk.  One of our traders stood up, pointed to the TV screen and we all stood there in stunned quiet as we stared at the screens.

Then we hunkered down, waiting for a flurry of calls, and opened a direct line with our custodian to execute trades, but before anything happened, it was over and stock prices were back to normal.

While it was clear that there was some kind of computer error in the market’s plumbing, no one could really say what happened.  The government released a report a few years later that pointed the finger to a regional broker, who then denied that they had anything to do with it.

Now the British government has arrested a trader on behalf of the US government that was operating out of a modest house in the outskirts of London, who they believe may have caused the flash crash for profit.

The government alleges that a single person, in their early 30s at the time, with off-the shelf software, engaged in market manipulation techniques known as ‘spoofing’ and ‘layering’, and made tens of millions of dollars setting off the flash crash and then trading in the chaos.

The basic idea behind these trades is to create the illusion that there is market activity that doesn’t really exist.

If you can convince other market participants through your own phony trades that there is massive, widespread selling, it might cause other market participants to sell, at which point you enter some buy orders and then cancel the sell orders that created the impression that there was a large, market moving trader selling.  In short, it’s a head fake.

The government alleges that one trader entered 19,000 trades in a specific futures contract in less than two and a half hours, or one-fifth of the total trading volume in that contract and canceled all of them before they were filled.

While those orders moved the markets, this trader then placed smaller, real orders to capitalize on the extreme market movements and supposedly earned almost $900,000 that day.  Over the next four years, he pulled the same trick, without creating more flash crashes, and earned an additional $40 million.

I have to admit that I don’t know what to make of this information.  I hate the idea that one trader could manipulate market prices in that way.  In fact, I hate it enough that I’m not sure that I really believe it, but that could just be my own bias.

I also have to wonder why it took regulators five years to catch this guy if he is guilty.  Why was there no mention of a mysterious trader in the report a few years ago?

While I have far more questions than answers at this point, I go back to one of my original conclusions at the time of the flash crash: things got out of whack, but people realized it quickly and prices got back to normal.

Part of the reason that stocks crashed in 1987 was technical overload – the market couldn’t handle all of the selling that was coming in and it paralyzed the system for days.

In this case, computerized trading systems could see a problem and pulled out.  Once the humans got a look at it, they say that it was a glitch and that prices were not right, they turned the computers back on and trading resumed.

Unfortunately, I think these kinds of things are part of living in a complex, computerized world.