Portfolio

Lessons from the flash crash

SAYEE SRINIVASAN | Updated on November 23, 2017 Published on May 21, 2011

The Indian markets have for long had price limits at the stock level. They are tight enough to ensure that a flash crash of the kind that happened on May 6 last year will never happen in India.

A recent Google search on “May 6 Flash Crash” returned 11,700,000 results. The term flash crash is now part of the standard vocabulary of traders and market participants.

It has also become a much abused term as it is now used as a proxy for anything related to potential negative impact of electronic trading.

Market crashes triggered by system and human failure are more common than the lay reader would expect. But the May 6, 2010, event has been given special status because of its magnitude:

According to Wikipedia, the crash “was the second largest point swing, 1,010.14 points, and the biggest one-day point decline, 998.5 points, on an intraday basis in Dow Jones Industrial Average history.”

There is broad consensus among market intermediaries in the US that retail participation in the US markets dropped in the aftermath of the event.

While trading desks were busy trying to figure out which firm's order triggered the avalanche, regulators and market structure experts have been busy trying to get to the root cause.



Circuit breakers

As is the case in India, exchanges in the US have circuit breaker rules which cause trading to pause for a pre-defined period of time or halt trading for the day depending on the quantum of the change in index levels. Interestingly, the index movements on May 6 were within the specified bands and did not trigger trading halts. More interestingly, the discussions related to the post-mortem of the event have not raised any questions on narrowing these bands. Clearly, regulators, exchanges, and market participants, both retail and institutional, are comfortable with the current index-based circuit breaker arrangements.

The discussions instead have focused on the fact the while the index movements were within ‘acceptable' limits in the sense of not necessitating any trading halt, extreme price movements in specific stocks were unacceptable.

For example, two key stocks in the Dow Jones Industrial Average, Proctor and Gamble, and 3M declined by about 36 per cent and 18 per cent, respectively. A quarter of exchange-traded funds (ETFs) listed in the US saw price declines of more than 50 per cent. A total of 326 securities witnessed price declines of more than 60 per cent from their 2:40 pm prices.

A year ago, the US markets did not have price limits on individual stocks. As a result, one could place orders at absurd prices; which is what happened on May 6. less. So if you had submitted a sell market order to be executed “at the market price”, post 2:40 pm on May 6, , your order would have been executed at ridiculously low prices. On the other side of the trade were market participants who had submitted limit orders at these low prices. In some exchanges, to qualify for any benefits that can accrue to a market maker, the firm might be obligated to enter buy and sell orders in form of limit orders. Most exchanges typically require that these orders be within a reasonable price band around current market prices — at least for a substantial amount of the time.

If an exchange did not specify any such restriction, a firm could get away by submitting ridiculously low bids, and incredibly high orders. Even with restrictions, most exchanges do not require tight quotes 100 per cent of the time. In the event of unusual volatility, software problems, or other issues, many exchanges allow market makers to widen or remove their quotes for some period of time.

Imposing price limits

On May 6, a large number of sell orders at the market price got matched against such orders submitted by market makers. Regulators and exchanges have acted quickly to plug the hole in the rules — price limits have been imposed for all stocks. These will operate in the same way as circuit filters or breakers for indexes. As is typically the case with such rules and regulations, these limits will get tweaked over time, it appears as if stock specific price limits are here to stay in the US markets.

Fortunately for us, the Indian markets have had price limits at the stock level for a long time now. The specific limits could vary with the underlying liquidity, but they are tight enough to ensure that a May 6 Flash Crash event will never happen in India. Our regulators and exchanges have clearly been ahead of the curve in implementing measures to prevent extreme events triggered by technical, rather than fundamental factors, from adversely impacting market sentiment.

(The author is Head -Product Strategy, Bombay Stock Exchange Ltd.)

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