The 2010 Flash Crash

On 6/May/2010, stock indices and equity-based product prices all over the world fell abruptly and rebounded immediately afterwards within some minutes.

Indeed, between 02:00 pm and 02:46 pm the Dow Jones Industrial and the S&P 500 fell around 8% and 7%, respectively. And, at 03:00 pm such indices were down only around 3% and 2%, respectively, in relation to the 02:00 pm price. Nonetheless, none of the market-wide circuit breakers was triggered in the US markets.

In addition, some instruments recorded very severe price drops, with trades happening at the penny level, as stub quotes were fulfilled.

The SEC/CFTC report key lessons

The SEC and the CFTC, in a joint effort, issued an extensive report on this flash crash, including a set of key lessons learned, from which we highlight:

• "Under stressed market conditions, the automated execution of a large sell order can trigger extreme price movements, especially if the automated execution algorithm does not take prices into account";
• "The interaction between automated execution programs and algorithmic trading strategies can quickly erode liquidity and result in disorderly markets";
• "Especially in times of significant volatility, high trading volume is not necessarily a reliable indicator of market liquidity";
• "As demonstrated by the CME’s Stop Logic Functionality that triggered a halt in E-Mini trading, pausing a market can be an effective way of providing time for market participants to reassess their strategies, for algorithms to reset their parameters, and for an orderly market to be re-established";
• Lack of transparency about when and which trades will be cancelled (broken) can affect market participant's trading strategies and market maker's willingness to provide liquidity;
• "The events of May 6 clearly demonstrate the importance of data in today’s world of fully-automated trading strategies and systems";
• "Although we do not believe significant market data delays were the primary factor in causing the events of May 6 (...) another area of focus going forward should be on the integrity and reliability of market centers’ data processes, especially those that involve the publication of trades and quotes to the consolidated market data feeds."

The cancelled (broken) trades

According to the SEC/CFTC report, over 20.000 trades representing 5,5 million shares were executed at prices more than 60% away from their 2:40 p.m. values. Such trades were subsequently cancelled by the exchanges and FINRA, as they were considered to be clearly erroneous and only to have happened due to the extreme disorderly trading conditions.

Almost two-thirds of shares in cancelled trades were executed at prices of less than $1.00, and about 5% were executed at prices above $100 (see stub quotes).


The new circuit breakers

Due to the flash crash, the SEC, FINRA and the exchanges engaged in discussions to improve the circuit-breaker mechanisms in the US exchanges, deciding to implement a pilot program for individual securities, through which trading pauses for 5 minutes whenever a security has experienced a 10% price change over the preceding 5 minutes.


The new rules to cancel (break) erroneous trades

In addition to the circuit-breaker pilot program, the SEC also approved pilot trade break procedures.


The Navinder Sarao case

Navinder Singh Sarao was arrested at his home in the UK on 21/April/2015, as he was charged by the US authorities with 22 counts of fraud and market manipulation for having allegedly engaged in spoofing and, with such practice, contributed to the flash crash of 6/May/2010. The US authorities sought his extradition, to be trialed in a US court.

This case was highly controversial in the public debate, as many wondered how one single person trading from home could have had caused such a large damage in the financial markets. Indeed, many considered that Navinder Sarao was just being used as a scapegoat.