Before understanding what causes a “flash crash” in the markets, let’s first differentiate between “flash trading”, which does not occur in India, and “flash crashes”, which have occurred.

Unfair edge For flash trading to occur, exchanges need special rights to be able to ‘flash’ orders to privileged traders for a fee. The benefits of a trader getting access to flash orders are tremendous. But this is not allowed in India.

In the US, flash trading was common until 2009, after which regulators tried to put an end to the practice. To understand flash trading, let us assume that Apple stock is showing a $600 bid and a $600.05 ask, with 25,000 shares offered at both sides. If I have the special privilege (for a fee) of seeing that 500 shares of Appleare going to be bought at $600.05 before the public, I can quickly purchase the remaining 24,500 shares at $600.05 and drive the stock price up. I'm making a bet that (thanks to the privileged information), I will be able sell and offload 24,500 shares of Apple stock for a price higher than $600.05. Hence, I get an unfair edge over the public.

Making a mistake A flash crash, on the other hand, occurs when algorithmic trading goes wrong in one way or another. This can occur because of two reasons.

The fat finger/freak trade: This is usually the reason for flash crashes in India. In algorithmic trading, the exchange and broker have the responsibility of ensuring that risk management is kept under control. This includes pre-trade checks such as ensuring that the trade size, value, and orders per second are kept within bounds. When a huge order is unintentionally executed and, worse, accepted by the exchange, a flash crash can occur. This happened on June 1, 2010. A trader accidentally placed a sell order for 500,000 shares on Reliance stock at ₹846. However, the problem was that ICICI Bank stock was trading at ₹846 while Reliance was trading at ₹1,028. Within seconds, Reliance shares fell to ₹840, an 18 per cent decline. This led to other traders selling Reliance stock. Since Reliance is a heavyweight, the entire market fell . However, the stock recovered after the market realised that the price drop was due to a mistake.

The second way a flash crash can occur is with high frequency trading (HFT) algorithms “signalling” each other with trade triggers, one after another, causing a massive sell-off. This, fortunately, has not happened in India. Let's assume two HFT firms are trading the same stock. Each firm runs an algorithm, wherein if the stock price falls by 1 per cent, it signals a sell trade. If both firms keep triggering each other, this can cause a huge sell-off and set off panic.

Due to stringent requirements on both the exchange and broker's side, flash crashes have been kept under control. As more and more firms and individuals enter algorithmic trading, let’s hope that flash crashes are kept under check in the future as well.

The writer is Raghu Kumar, Cofounder, RKSV

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