The Financial World and The Implications of The 2010 Incident

The financial world and economy can sometimes be similar to a rollercoaster, it has its ups and downs. There have been many historical incidents were crises and economic turmoils have been recorded. These incidents can disturb the economy greatly or it can just pass by as a minor fluctuation. In 2010, a little more recent economic disturbance, the flash crash had occurred. The flash crash was a period of time where there were a quick drop in securities, but it also was recovered, fortunately.

This incident had occurred on May 6th around 2:30pm eastern standard time. The flash crash was one of the biggest point of decline in a single day in the history of the Dow Jones Industrial Average. Primary market makers that were in the stock market had stopped taking the other side of everyone’s trades automatically, so therefore this made the market illiquid. Sell orders did not have immediate bids for a few minutes. Initial reports had said that the crash was a result of a mistyped order that proved to be incorrect, but the causes of the flash crash has remained unknown, although both the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) had investigated the situation.

The Dow Jones Industrial Average was already down by 4pc and continued to plummet to 6pc in such a short time period. Literally minutes. Although it was able to recover quickly, the index closed about 350 points lower still. About 8,000 shares and exchange traded funds had declined in price following with a recovery. Most of the shares at fell around 15pc before it had recovered later that day. Not only did it affect U.S. markets, but it affected European markets as well. These European markets began to follow suit as the U.K., France, and Germany’s market had fell.

A little history before this event occurred is that stocks used to be monitored by “specialists” that worked on trading floors of stock exchanges. These specialists were in charge of keeping up with the market and making sure that it was in good order. This would temporarily take other sides of the trades when unmatched orders to buy or sell would come in. The government were not particularly fond of these specialists. They were constantly being accused of cheating investors. Policy makers tried to do everything they could in order to replace these specialists with computers. This resulted in much of the liquidity in the market coming from high frequency trading computers. These computers were able to transact trades at the speed of light. In order to make money, they would transact a large volume of trades at small price points and they would do this often.

Both the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC) had released a report on this incident and the report had gave some theories and hypotheses about why the flash crash may had occurred, but these assumptions had failed to identify a specific reason for what had caused the incident. During the crash, the SEC had canceled about 21,000 trades due to the fact that they were transacted at very unexpectedly low prices. On June 10th, the SEC had voted in order to establish new rules that would automatically stop trading for any stock in the S&P 500 whose price had changed by more than 10 percent in a five minute period.

It is thought that the reason why the system broke down was due to well-informed traders coming in the market, which can make it hard for these high frequency trading computers. Reason being is because during certain parts of the market cycle, trading is less random and more rational. Actively managed hedge funds can benefit from this as well due to the fact that they can make a big amount of money from it. In turn, it makes it very costly for high frequency trading computers. Since these traders were taking advantage of these high frequency trading computers, they were making a lot of money and due to the loss of money, these high frequency trading computers put trading to a halt. The computers had decided to pull out and wait until the market began to become random again. Without specialists or high frequency trading computers, the market can become very volatile, which is a lesson that had been learned.

It has also been alleged by the US Commodity Futures Trading Commission that Navinder Singh Sarao, a futures trader that is based in the UK, had triggered the collapse of the stock market that caused the biggest companies in the world to lose billions of dollars, which they had arrested him for. It is said that he had allegedly agreed to sell assets for a certain set price in exchange for payment that would occur at a future time period, but he had never intended to complete these transactions. “The CFTC has charged Sarao with unlawfully manipulating, attempting to manipulate, and spoofing (placing orders to buy or sell an asset without the intention of completing the deal, and then cancelling it) — all with regard to the E-mini S&P 500” (Trotman 2015). It is claimed by the CFTC that Sarao had used a particular computer algorithm in order to place a large volume of orders to sell E-mini S&P 500 stocks without intent to ever complete the agreement that was made. The orders were strategically priced competitively as well as not attracting too much attention and not standing out since the prices were not unexpectedly high or low.

This technique that Sarao used is known as layering where Sarao was about to create the appearance of a considerable supply in the market. It was also said by the CFTC that Sarao has traded in other shares in order to make a profit from the large market movements that his fake orders had created.“The CFTC and SEC stated: "At 2:32pm, against [a] backdrop of unusually high volatility and thinning liquidity, a large fundamental trader initiated a sell program to sell a total of 75,000 E-mini contracts (valued at approximately $4.1bn) as a hedge to an existing equity position” (Trotman 2015). Sarao was able to execute this within just 20 minutes. The CFTC stated that Sarao made approximately $40 million from his alleged scheme from April 2010 to April 2015.