The May 6, 2010 mini stock market crash will certainly be remembered as a historic economic event. Although it wasn’t the biggest market crash ever, it was certainly the fastest and scariest-especially for those who watched, live, the value of their portfolios get cut in half in mere minutes. The latest finance textbooks are no doubt already incorporating the "flash crash," as it was termed by the media, into their coursework, and 20 years from now, college professors will use it as an example to teach their students "proper risk management" and new quantitative methods for protecting portfolios.
But what really happened and who is to blame? This is what the report released by the Securities and Exchange Commission on Oct. 1 tried to explain.
Days after the crash, anger among politicians and media pundits was nearing a boiling point. There seemed to be a real urgency to blame someone for the stress and losses caused by the crash, and thus the wheel of blame began to spin. At first there were rumors that an erroneous execution by a large bank had caused the crash. But no large bank came forward to confess, and there didn’t seem to be any evidence for that theory anyway.
Then attention shifted to the exchanges and ECNs, which were accused of being unable to handle the massive trading volume and implementing proper circuit breakers. Again, the exchanges and ECNs refused to accept responsibility for the crash, and the wheel of blame continued to turn.
Finally, it landed on its favorite target, good old high-frequency trading. Politicians and academics alike practically unanimously agreed, the crash was caused by high-frequency trading. How? No one had a real answer. But when you are dealing with a mob mentality, who really needs logic? It just seems more convenient to act on emotions. And so, when the SEC announced it would investigate and report on the May 6 events, the eager opponents of high-frequency trading waited for the curtain to finally fall on this "predatory and malicious" behavior.
When the SEC at last released its findings on Oct. 1, there seemed to be much confusion. First, it didn’t single out any entity, it didn’t point to any systemic problems, and it didn’t suggest any heavy-handed changes for the markets or their participants. Second, and perhaps more shocking, it did not fault high-frequency traders for the carnage caused that day. In fact, in one of the few mentions that high-frequency traders did get, they were recognized as having initially absorbed much of the selling volume. Who would have guessed? The mob was wrong, and Frankenstein is actually a good guy.
Lack of liquidity and market depth are what the SEC’s report suggests caused the crash. After a large sell order came into the S&P 500 futures, the markets began to fall. When prices began to drop and trading volume picked up, many market participants pulled their orders from the market, which in turn caused the sell velocity to accelerate. It probably didn’t help that TV networks reporting on the crash simultaneously showed footage of riots and protests in Greece, which was going through a very rough economic transition. Because of this, I don’t blame the market makers and liquidity providers for pulling their orders: If you see a locomotive hurling toward you at full speed, you don’t wait for it to stop two inches from your nose. You jump off the tracks. Self-preservation has to be at the heart of every trader’s core strategy.
Unlike many reports and journals that found the SEC’s report to be anticlimactic and lacking in real answers, I think the report did a good job. It didn’t succumb to the pressure of singling anyone out, and it didn’t fault any particular trading practice. Most important, it revealed that nothing was broken.
The May 6 crash, like so many market crashes before it, has to be viewed from a historical perspective. It certainly was not the first market crash; there have been many others over the centuries in different markets and countries. Despite our faith in rigid economic theories, markets are and will remain driven by human emotions. Those emotions can be translated into algorithms and black boxes, but those in turn will only reflect the imperfect thoughts and strategies of their creators.
Gennady Favel is the head of equity trading for an algorithmically driven hedge fund and the author of "The Stock Market Philosopher," published in 2008 by W&A Publishing.
The views represented in this commentary are those of its author and do not reflect the opinion of Traders Magazine or its staff. Traders Magazine welcomes reader feedback on this commentary and on all issues relevant to the institutional trading community. Please send your comments to Traderseditorial@sourcemedia.com
