Why A Flash Crash Can Happen Again
Today is the 5th Anniversary of the Flash Crash (above is a Bloomberg screenshot from that day). Over the past few days, we’ve been asked often if the Flash Crash could happen again. The short answer is yes. While regulators have addressed a few issues to reduce the risk of another Flash Crash, another crash could still occur because of underlying structural issues as well as the lack of advanced regulatory surveillance.
What have regulators done since the Flash Crash?
– November 2010 – Removal of stub quotes
– July 2011 – Sponsored Access (Market Access Rule 15c3-5) – risk management controls for brokers who sponsor access
– May 2012 – Limit up/Limit down (5%,10%, 20% depending on market cap). Also, updated market wide circuit breakers (7%, 13% and 20%)
– Dec 2014 – Reg SCI – was just finally approved and will strengthen systems stability, capacity and security, prevent market disruptions (but leaves out large b/d’s)
– Ongoing – Exchanges have tightened some loopholes particularly order types
While the above changes are all sensible, they do not get to the heart of the problem that caused the Flash Crash.
Why can a Flash Crash still happen?
– Liquidity is fragmented and fleeting, which is the fundamental problem in our markets.
– Market makers are good at managing their own risk, which is very short term; but they do not have strong enough obligations to stand in during periods of market duress, and that can always exacerbate a big market swing (It is important to note that some market makers have recently argued in favor of stricter obligations).
– The October 15, 2014 treasury bond market “flash crash” proves that this type of event is not unique to equities.
– Regulators still do not have the surveillance systems in place to actively monitor the market.
We’d like to take a moment to focus on that last point since we have been writing a lot lately about how the SEC and CFTC does not have the resources and technology to surveil todays markets. To prove our point, take a look at the below statement from former CFTC Commissioner O’Malia regarding the CFTC budget (this statement was from March 2014):
–“Given this funding plan, the Commission will waste another year without deploying critical technology, such as an order message data collection and analysis system, a key tool for surveillance. Without this investment, the Commission will not have access to the millions of order messages that flood the exchanges on a minute-by-minute basis in order to conduct complete market surveillance for abusive trading practices. Instead, the Commission will continue to rely on transaction data that is submitted to us by registered entities, which represents only 8 percent of the millions of order messages. Thus, the Commission will continue to have an incomplete picture of overall market activity.”
Mr. O’Malia was basically saying that the CFTC does not have the capability to monitor orders on a real time basis. Last week, CFTC Chairman Massad backed up this statement when he said::
“We don’t have the resources to look at message data on a real-time basis or even a regular basis,” Massad said. “I’d like to be in the position to do more.”
And of course, we all know by now the problems that the SEC has had in creating the Consolidated Audit Trail (CAT). The WSJ featured this issue today in a piece titled “Flash Crash Overhaul is Snarled in Red Tape”. Shouldn’t we demand more from our regulators than incomplete surveillance systems?
Our securities and futures markets are closely linked, and yet the SEC and CFTC, the respective regulators of those markets, do not work together on analysis and enforcement. The reasons for their separation are no longer relevant which is why we think a merger of the two regulatory bodies makes sense. A merger might solve some of their budget constraints and would allow for the sharing of critical information.
After five years, our markets are still experiencing frequent mini-flash crashes and other market structure related events like exchange malfunctions and the failure of the SIP. Unfortunately, market participants no longer seem to make a fuss about these disruptions and seemed to have normalized these deviant events. Rather than sitting back and accepting these events as “normal”, we think market participants should demand more from our regulators.
And just in case you forgot what that day on May 6, 2010 felt like, please listen to this audio listen to this audio .