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Focus: Flash Crash and systemic risk - analysis and observations

Published in Automated Trader Magazine Issue 19 Q4 2010

Systemic risk and the 'Flash Crash'...analysis, discussion and conclusions


Flash Crash: A Smoking Gun?

With US regulators still combing the evidence for the smoking gun, Alison Crosthwait offers Instinet's "Flash Crash" analysis and conclusions.

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Flash Crash - The Hunt for Weapons of Market Destruction

Bob Giffords scours September's CFTC/SEC "Flash Crash" report for the regulators' conclusions, lessons and remedies

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What just happened?

What happened, and how do we handle it better next time? The 'flash crash' of 6th May 2010 wasn't just a random event. It was the culmination of a causal sequence that has important lessons for high-frequency and other traders. There was the 'perfect storm' of external factors - Greek debt crisis, Gulf oil leak, UK election - coupled with the market impact of big trades that accelerated the directional push, all tied up with a tsunami of real-time data describing what was happening as it was happening, topped off with self-defensive reactions of exchange systems. In short, the market snarled itself up into a 'flash crash' just as - from some perspectives - everything came right for a busy day's trading.

Days like that shouldn't turn out like that. Trades shouldn't need to be cancelled in exciting times. In this feature, Bob Giffords speaks to traders who were in the market on the day; to the trading venues; to key players at every point on the trade cycle, to establish, first, how it was for them, and secondly, to draw up a set of best-practice suggestions for next time.

Anatomy of a Crash

There's high-frequency trading, and now there's high-frequency crashing. But identifying the causes of the 6th May 2010 'flash crash' has proved to be a relatively slow process. Bob Giffords goes in search of causes, outcomes, explanations and lessons to be learned.

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Diana Chan, Chief Executive Officer of EuroCCP - click here to view the entire interview

There are many challenges for high frequency traders these days. Losing a prime broker in a Lehman Brothers failure or suddenly finding yourself with busted trades in another flash crash could totally disrupt your liquidity, just as you face unexpected margin calls. Diana Chan looks back on the tumultuous events of both September 2008 and May 2010 in the US markets, and tries to draw some conclusions. She notes that a sudden shift of fortunes intraday could now trigger intraday margin calls for clearing and execution brokers as well, with potentially systemic impact. So clearing-houses constantly need to monitor shifting exposures and weigh up the risks against the instability that could also flow from a trigger-happy margin manager over-reacting to an unexpected trading storm. As Diana Chan explains, in the end decisions will be based on that old fashioned concept of 'know your customer' and careful preparation.

However, big changes are also afoot in the European post trade system as the European Commission releases its consultation papers on clearing and settlement, derivatives and market infrastructures. The EuroCCP CEO contrasts the European with American practice and outlines the significant challenges for interoperability and competition that lie ahead.

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Bob Fuller, non-executive director of Fixnetix - click here to view the entire interview

While most of us are focused on unraveling the past to learn its lessons, Bob Fuller is looking to find the next pothole we are likely to stumble over. He doesn't need to look further than the mad pace of change targeted by our political masters and their financial regulators, which he describes as 'absolutely unreal'. He points to the market structural implications of all this change -- which have already begun -- and the likelihood of inconsistency, gaps and contradictions, concluding that many bankers may simply postpone decisions until the dust clears. As President Obama signs the Wall Street Reform Act into law, twelve months of regulatory rule making now begin, so there is still everything to play for or pray for. Meanwhile Europe debates its own response with rather different ideas, but equal if not greater ambition.

Bob Fuller sympathises with financial technology managers trying to set priorities and budgets in such an uncertain world where everything impacts on everything else. In the end he sees inevitable pressures promoting industry collaboration and outsourcing solutions and some hard decisions over what is 'business critical' versus 'business differentiating'. We certainly live in interesting times.

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Hirander Misra, co-founder and chief executive of Algo Technologies - click here to view the entire interview

The technology arms race is driving both change and systemic risks, which is why people simply cannot opt out. For Hirander Misra the snowball of Moore's Law rolls on, gathering momentum as latencies plummet and volumes soar. Yet he brings good news as well, since technology offers dramatic reductions in energy footprints, despite enabling ever-higher-frequency strategies. Therefore, by referencing sponsored access he sees light at the end of the wormhole that is driving through the black hole of technology turbulence.

The co-founder of Algo Technologies also provides interesting insights into the risk-averse trader psychology that abandoned struggling US markets in the fateful flash crash of 6 May. He then scans the horizon for what will shake things up next. Will it be his new matching engine that knocks spots off the competition or will it be cross-asset trading in a box, the one-stop-shop that everyone wants, but remains incredibly elusive? He certainly seems to have his finger on the pulse as he charts the future of 'split co-lo', distributed trading. In a world beset by gloom and doom, Hirander Misra shines the bright light of optimism and innovative zeal. 'When the going gets tough, the tough get going', they say.

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Richard Balarkas, President and CEO of Instinet Europe - click here to view the entire interview

What are markets there for anyway? Who's now calling the shots? So begins Richard Balarkas with a fascinating review of how technology has removed archaic structures and inefficiencies, increased buyer power and in effect democratized the financial markets. Only the markets themselves still haven't woken up to that fact. He concludes that what happened on 6 May was an entirely predictable surprise. He also challenges some pretty fundamental cornerstones of the US system including the trade through rules and suggests that regulators may be asking the wrong questions. For example, did existing market rules actually facilitate the failure by allowing market orders, penny prices for stub quotes and snake-in-the-grass orders in the first place?

How does Instinet then protect its own clients using clever trading algorithms? Can human traders provide an effective back-stop in the surging electronic tides of 21st century markets? What pitfalls lie in wait for the unwary European trader like backwardisations or perverse cross-market scenarios? Instinet Europe's president asks some pretty challenging questions to clients who dare to trade through a volatility interrupt auction or who think that 'what they see' is 'what they'll get'. The markets have clearly come a long way, but for Richard Balarkas it's only just beginning.

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Andrew Morgan, Head of Autobahn Equity Europe at Deutsche Bank - click here to view the entire interview

Have we created too much diversity and complexity in our market infrastructure thereby increasing systemic trading risks? Should we not, perhaps, exclude some areas from competition, such as tick sizes or volatility limits, just to make markets more tractable without sacrificing competition, innovation and efficiency? Andrew Morgan suggests that an appropriate level of consistency across the various pools of liquidity is vitally important, if the extreme dynamics of the flash crash are to be avoided in future. He explains how Europe's volatility controls offer some advantages over the American model on the 6 May, but here too identifies inconsistencies that may harbour complexities and risks that need to be addressed.

Watch the video for Andrew Morgan's view on the need for a more regular review of the technology risks emanating from superfast trading to ensure a rich toolkit of regulatory safety features to reduce the likelihood of crashes, as is common practice in the car industry. However, he is quick to reassure us that at least in respect of sponsored access, as in the UK, controls are in place to ensure that this will not be the next predictable surprise, and recognizes that rapid pace of change is ramping up the need for market expertise.