XMFRedwood (84.67)

Normal Crash, Insane System

August 06, 2010 – Comments (1) | RELATED TICKERS: WDR , VXX , IVV

A front page Wall Street Journal article today looked back at the Flash Crash of three months ago, a subject I'm very interested in.  

This was an normal crash in an insane system.  Equity markets broke down completely.  Here are a few thoughts:

* The system broke down due to huge selling pressure.  Usually you have a normally matched pool of buyers and sellers but in this case there was a huge shift over to the seller side which not only affected trading strategies but also overwhelmed computing capacity, slowing down orders, which further added to the confusion and panic.  

* Liquidity dried up and insane things happened.  As the market went down, market makers and buyers pulled out, leaving little liquidity and buying demand.  At one point only 4,105 shares of Apple were available to buy on ARCA, one of the biggest trading platforms.  An order was put in for 5,000 shares and because there were only 4,105 available the remainder were bought at a default price of $99,999.  Accenture dropped to pennies from $40 in a second and bounced back up again.

* The "fat finger" never happened.  The fat finger was a rumor that someone entered a few extra zeros into a trade that set off the crash.  At the time, the rumor helped stabilize the market because it led people to believe that the fall was due to an error and that things were ok.  Little did they know that there was no error... This means the crash was real... and extra scary, from our perspective. 

* 96% of online poll respondents think it can happen again

Who’s To Blame?

This is the wrong question -- no one is to blame.  It’s a natural occurrence in a system of this nature.  As our financial system gets more and more complex, these types of events will occur, and on very large scales.  It’s not just the high frequency traders, everyone is involved.  Consider the role of Waddell & Reed.  Waddell & Reed was founded in 1937 in Kansas and is now a large mutual fund manager that states on its website: “Our investment approach has always been based on fundamentals over fads. We use a conservative and consistent process…”  It’s not a high frequency trader.  However, WSJ reports that its portfolio managers decided that day to short the market, which some say set “accelerated the selloff,” according to the article.  So is Waddell to blame?  Of course not. 

This sort of crash is a natural occurrence in our financial system and will happen again.  Next time it could be worse. 

Andrew