Flash Crash

On May 6, 2010, Wall Street witnessed an unforeseen slump in the S&P 500 key index and the Dow Jones Industrial Average, which fell by 1000 points within minutes. Some stocks temporarily lost 90 percent of their value. However, the crash was short-lived. Several minutes later, rates shot up again.

Financial experts refer to this type of extreme stock exchange rate drop within an abnormally short amount of time as a flash crash. This is a relatively new phenomenon. Smaller flash crashes are simply referred to as “mini flash crashes”.

The rate collapse of May 6, 2010 is often considered to be the first flash crash. Another incident which earned the flash crash tag was the rate drop of April 23, 2013. This flash crash was caused by a false tweet published on a hacked Associated Press Twitter account and knocked 130 points off the Dow Jones Industrial Average for a short period.

In a regulated stock exchange, the market index is based on a defined number of the largest and highest-value companies and their stock prices. Supply and demand define the price of stocks and therefore the index. In a stable economic situation, no sudden changes to overall supply and demand occur. Indexes remain stable.

In the event of a stock market crash, the normally stable system is thrown off balance, leading to major drops in rates. Stock market crashes already existed in the past. The crash of October 24, 1929, which led to the collapse of the U.S. stock market, is one of the most famous. In that crash, rates fell to half their previous values within six days. The day the stock market began to collapse became known as “Black Thursday” and led to an economic depression which affected most countries across the world.

Unlike conventional market crashes, flash crashes occur much faster and far more aggressively. So far, market rates hit by a flash crash have rapidly recovered to their former levels, partially within the same day.

Unlike previous rate collapses, today’s markets are quicker to react to market relevant incidents. New digital forms of communication which deliver stock market news around the world in a matter of seconds are one reason for this change. The fact that a large number of trades are now performed automatically via algorithmic or high frequency trading is another.

The flash crash of May 6, 2010 left many U.S. traders and authorities puzzled as to what could have caused rates to fall so suddenly and recover so quickly. Whether high frequency trading played a hand in the phenomenon was highly debated. But what exactly caused the flash crash?

Only after an embarrassing five years did investigators finally trace the cause of the flash crash. A London-based stock trader had used computer assisted trading to automate sales of over a billion stocks, which they cancelled immediately afterwards.

High frequency trading enabled six times the typical daily amount of securities to circulate on the stock market. 1.3 billion shares hit the market within ten minutes, pushing the market to its limits. Through this interruption, the manipulative trader provoked numerous sales from other investors, with the aim of profiting from resulting rate drops.

In the meantime, U.S. financial authorities have imposed stricter regulations on high frequency trading, with the aim of preventing similar manipulative moves. However, stock exchanges are still far from immune to future flash crashes. Technology is developing at a furious pace, and with it, the opportunities for potential market abuse.

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Expert Benjamin Manz
Benjamin Manz is CEO of moneyland.ch and an independent expert on banking and finance.