GORDON T LONG
"Go back to the 1987 crash, every major firm pulled out," said Chris Concannon, a senior partner at Virtu FinancialLLC, a New York electronic market making firm, which continued trading during the May 6 turmoil. "In every breakyou find evidence of major firms withdrawing their buying and selling interest from the market." (2)The Financial Times on June 1
wrote:Traders were stunned. “We thought a big European bank was about to go under, that this was it,” says a dealerwho was on one of the big trading floors at the time. “Everyone got on the phone. Then, traders quickly realisedthat the falls were due to lots of automated sell orders. At that point
we all just wanted to reach for theemergency button and press stop.”
While there have been times in equity markets where some stocks havemoved wildly, the afternoon that has become known as the “flash crash” was the first time that the entire USequity market was convulsed by such turmoil.
But 20 minutes later prices had bounced back. Trades that tookplace during that dramatic slice of the hour where the movement was more than 60 per cent were cancelled. Yetthe impact of the flash crash will be felt for a long time to come, not least because it showed that
the equitymarkets do not have such an emergency button, or any way to halt trading when something goeshaywire
MESSAGES OF THE FLASH CRASH:Liquidity Driver
Dynamic Hedging and Portfolio Insurance are both based on trend following mechanics.Consequentially both have a strong bias towards momentum correlation and the ability to adjust tochanges in momentum.One of three flaws in most mathematical algorithms is the assumption of market liquidity. Whenmarkets breakdown, liquidity quickly evaporates and this often makes execution impossible. Themore serious the breakdown the more serious the liquidity problem will become. Also, the liquidityissue is often simultaneously seen across multiple markets where modern dynamic hedgingoperates.The Flash Crash confirmed that Dynamic Hedging has now been modified by major players to takethis into account and this is why the algorithms ‘grabbed’ as much liquidity as fast as it could, ataccelerating rates - while liquidity was still available. The employment of High Frequency Trading hasnow emerged as a strategic imperative within state-of-the-art Dynamic Hedging Systems.
Counter Party Risk Driver
A second flaw of trading algorithms and markets is counter party risk or the sudden failure of acounterparty to deliver a contracted obligation. With banks & financial institutions still having seriousamounts of off balance sheet risk tied to Structured Investment Vehicles (SIVs) and corporations toSpecial Purpose Entities (SPEs) the ability to rapidly shift hedging on any early indications is nowparamount.Shifts in LIBOR, TED Spread, and OIS-Swap spread must now be acted upon in milliseconds. TheFlash Crash occurred when all these input drivers were moving as a result of the Euro crisis.