Fight against ‘Flash Crash’ takes cash
Prevention still an issue 5 years later
Five years ago on Wednesday, I turned down Jackson Brown’s Running on Empty on the car radio to answer a call from my office. The Dow Jones industrial average had dropped hundreds of points in a short time. As I spoke with surveillance experts, the market plummeted another 500 in 25 minutes (totaling nearly 1,000 points). Miraculously, within minutes it recovered almost completely. This freaky event became known as the “Flash Crash.”
On Tuesday, we were still talking about it, this time in the halls of Congress. Running on Empty remained the theme song. Mary Jo White, chair of the Securities and Exchange Commission (SEC), and Timothy Massad, chair of the Commodity Futures Trading Commission (CFTC), in a joint appearance before Congress said that we’re still dealing with the Flash Crash, and investigators needed more resources to get their enforcement jobs done.
In the moments after the crash, financial regulators immediately scrambled to get data from exchanges such as the Chicago Mercantile Exchange (CME) and the New York Stock Exchange (NYSE). The news media sought to ascribe a cause: Was it a “fat finger” error — a trader, perhaps meaning to trade 10,000 of something had pressed 10,000,000? Was it intentional market manipulation or financial terrorism? Could it happen again? What should be done?
Over the ensuing days, innu- merable staff and commissioner meetings took place at my agency (the CFTC) and at the SEC. Extensive discussions were held with myriad market participants gathering information.
After detailed analysis (the results contained in a CFTC-SEC joint staff report), it was determined that while there were multiple conditions leading to skittish markets, a single trader had sold an incredible amount ($4.1 billion, 75,000 contracts) at CME in a short time period, thereby tanking Chicago markets and, with simultaneous contagion, devastating New York markets and even impacting other global trading venues. Unlike the old Vegas line, what happens in Chicago does not stay in Chicago, or New York, London, Hong Kong, Singapore or Sydney. Our markets are electronic and inextricably linked. They operate 247-365, and the stakes are high: Global financial regulators must coordinate when developing rules that govern market traders and exchanges. Where regulatory arbitrage can exist, it will.
In the wake of the crash, new measures called “circuit breakers” were put in place, market speed bumps, if you will. When a price falls or rises beyond acceptable levels, designated pauses allow traders to catch their breath and help calm jittery markets. CME employed these before the Flash Crash, but not all exchanges did so; the gap between what was required by the CFTC and SEC (accountable for different markets) was considerable, and as a result of lessons learned, that has changed. Are we safer? For sure, but in the past five years, we have still seen “mini flash crashes,” and regulators need to continue to look for ways to do better.
And now, the rest of the story ...
The third full week of this April, a lone London trader who worked from his home computer was arrested in connection with the Flash Crash. The news media raced to report that the “Flash Crash culprit” had been found. Pundits were just as quick to criticize regulators at the CFTC and SEC. Did they get it wrong, and why did this take five years?
As for why so long, we get the investigations we pay for. At any time, the CFTC alone is investigating 1,000 individuals or entities, with only a few hundred enforcement staff to do the work. It regularly takes years to complete investigations, especially when they involve (as this most recent case did) hundreds of thousands of trades. If better enforcement is needed (and in my estimation, it certainly is) then Congress should better fund agencies, as White and Massad told Congress on Tuesday.
The May 2010 joint staff report also yields more than a few clues. It references the $4.1 billion large trade but also hundreds of thousands of files, over 25 gigabytes of trading data, along with myriad potential issues and actions contributing to the crash. All the data and trades required further examination. The London trader appears to have been a part of that, although he allegedly undertook nefarious trading roughly 400 other days over a five-year period without inciting either flashes or crashes. The bottom line is that without the other $4.1 billion trade, the Flash Crash would not have occurred.
It’s easy to look for simple solutions to problems in our increasingly complex financial world. It’s also easy to criticize regulators. One writer recently referred to it as “using bicycles to chase Ferraris,” and there is more than a little truth in that analogy.
It is much tougher, but central to efficient and effective markets, devoid of fraud, abuse or manipulation, that we have solid, sensible and seamless regulations. They need to work for exchanges, traders/investors and, most important, for consumers and our economies. Those challenges remain.
We get the investigations we pay for. At any time, the CFTC alone is investigating 1,000 individuals or entities, with only a few hundred enforcement staff to do the work.