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What measures can be taken to prevent another "flash crash"?
What measures can be taken to prevent another crash like last year's "flash crash" in which the DJIA experienced its largest ever single-day decline?
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6 Answers
I think more is being made of this flash crash than is warranted. While it seems crazy, the market figured out the issues within a short time and corrected itself. Also, the market is beset with constant day and minute trading and this phenomenon is not going away. At any one time, an imbalance of sell orders against a stock can cause an unexpected decline, but such an imbalance will not last long and will be self correcting. Obviously traders that sold at the bottom and did not replace their positions quickly took a bath. But these are the risks of this kind of trading. There are stops in the system for excessive drops in the market, but it is not a good idea to try to manage the craziness that we often see.
There is a group of professional investors that try to make money on the moment by moment fluctuations in securities prices. This is what it is, and I don't see in any way how this harms longer term investors. In the end, the stock price will trade on the fundamentals and the day trading will not change this. The profits from this frequent trading are taxable and we might as well enjoy having these taxes when the government pays its bills.
I do think the government has a role in guiding the whole system towards transparency and reducing complexity of the trading instruments. Further, those trading in complex instruments need to be determined to be qualified investors capable of meeting the financial obligations under the terms of the instruments bought and sold. This is intended to prevent the situation for instruments like credit default swaps that were issued during the boom without adequate backing in the event of a call. If instruments cannot be tracked and qualified, they should not be tradable on US markets and US regulated financial firms should not be able to trade in them outside of the US.
I think some common-sense regulation around online and electronic trading platforms shold do the trick. What some of these trading and trending bots are capable of is out of control. Some have been tracked posting transactiosn at rates in the tens of thousands per second.
I first heard about these last year in the analysis after the flash crash. Here's a link to a good article about what they found.
http://www.theatlantic.com/technology/archive/2010/08/market-data-firm-spots-...
I don't think it matters much what caused the crash. Regulations will never cover all contingencies and with massive trading something is bound to go wrong. Investment strategy should focus on balance and diversification allowing minimal damage to a portfolio. Most overreaction corrects quickly.
Rick,
I'm not sure I share your opinion about the cause of the crash not being important. Scott Albro posted an interesting read this morning that goes into more detail about the impact of high-frequency trading and its role in the "flash crash".
http://www.lrb.co.uk/2011/05/19/donald-mackenzie/how-to-make-money-in-microse...
The problem I see with these high-frequency mechanized "bots" is that they take real-time reasoning out of the equation. Further, they can cause other bots to also react triggering uncontrolled domino effects through the market that have nothing to do with the underlying companies or even actual decisions being made at the time. Normal corrections in the market are rendered powerless to these systems. How can a trader who sold at an artificial bottom possibly recover their position in a few milliseconds? Long-term investors who think they can ignore this activity will find that the indirect effects of these activities will indeed hurt them in major ways.
Having worked in technology for so long, I know first hand how runaway processes can and do wreak untold havoc and can be very difficult to correct and recover. Given the highly distributed and reactive nature of these systems, the potential for widespread disaster is very real. The risk goes up exponentially with the introduction of malicious intent. As you know, the numbers and information that are being manipulated directly impact real people and real companies. If a company's stock price can be reduced from $40 to $.01 in a matter of seconds by accident, how much more damage can be done intentionally?
For these reasons, I believe we need to adopt specific regulation and legislation around what can and cannot be done with these tools. This type of regulation is inevitable in the long run, but I'd rather we were proactive and address it now rather than wait until major companies are suddenly unable to make payroll because their stock value literally disappeared in an instant.
I accept your reasoning but disagree with the conclusions. I think that regulation will be constantly behind where the market is going. Right now the fad is instant trading with companies locating their computers closer to the exchange to gain the millisecond advantage. I think this will pass in time as an absurd practice but it may take a while since a lot of "smart" money is behind the current practices. But the Flash Crash is actually a reminder to these folks that no matter what they do with their computers, they cannot control what thousands of other investors are doing at the same moment. If their systems panic and sell at very high losses, they have only themselves to blame. Long term investors just watch and trade when it is to their long term advantage, which may only be in decades.
Market trends are far more important than what happens in a millisecond. For example today, the market fell off about 1%. The trades up and down during the day did not offset the overall trend of down. Yesterday it was the opposite. But looking back from the market low about a year ago in July, the Dow has moved up 3000 points in a very impressive rise. This reflects that in general, corporations are doing well. This is the trend that will eventually be reflected in the market, so the flash crash and all the crazy day and minute trading is just not relevant to the wise investor. I wonder if the day traders have done as well as those who just sat out the market.
This is a really relevant question right now because, since about April 26, we have had a flash crash right across the Commodities and PMG (precious metals) group of assets
Like we will see every day, the linkage Commodities-Equities is now strong in a single global asset space where leverage is the rule, not exception. The oil market, for example and including petroleum products refined from crude, trades about 200 barrels of "paper oil" for every 1 real physical barrel. Cutting into this with big falls in the price of the "underlying asset", oil, will have fast and large spinoff impacts across the integrated asset space. Exactly the same apples to gold, silver, corn, rubber or other commodity asset.
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