On May 6th, 2010, the Dow Jones Industrial Average (DJIA) tumbled over 1000 points, which represented a plunge of over 9% within a couple of minutes. The DJIA dip was the biggest ever in its multi-decade history, and it wiped off over $1 trillion in market value in less than 30 minutes. The index quickly recovered a majority of the losses within an hour, with subsequent investigations revealing that the dip was caused by market fragmentation, general negative sentiment, and large directional bets executed by algorithmic strategies.
A flash crash is a sharp and sudden dip in prices due to the withdrawal of orders, with the market then quickly recovering, usually within the same trading day – ‘it all happens in a flash’. There is evidence that flash crashes are fairly common in the market, but the Flash Crash of 2010 still stands as the biggest and fastest ever in history.
How it Happened
It was hardly a normal day on May 6th, 2010. Markets were characteristically panic-gripped. The euro was weakening against both the US dollar and the Japanese yen as anxiety heightened over the Greek debt crisis. And in the US, the SEC was consolidating the Reg NMS (Regulation National Market System) so as to promote the best execution of orders in the markets. Market participants (particularly high-frequency traders) were keen to see the opportunities these developments would open up for them. But despite the underlying tensions, no one could have imagined what was about to transpire.
The market sentiment that day saw markets open with a generally negative stance. The bearish tone accelerated in the afternoon and by 2.00 pm, the Dow was down over 160 points. By 2.42 pm, the Dow was already down 300 points, before making a sharp 600 points plunge within just 5 minutes. By 2.47 pm, the Dow had plunged over 9% for the day, after losing about 1000 points. Stocks started rising again at around 3.00 pm, gaining over 450 points and recovering much of the sudden 600-point tumble. By 4.30 pm, the markets had recovered most of the losses and it then closed down only 3.2% compared to the previous day’s close.
What Caused the Flash Crash of 2010?
Everything that day happened so fast and there were no definitive explanations for the sudden 600-point dip in the markets. But there were some early hypotheses. A common one was that HFTs (high-frequency traders) were overloading the exchanges with orders that were not intended to be executed in the markets. By effectively clogging the exchanges, HFTs managed to disrupt the fractured equities trading systems and thus gained an unfair advantage over other ‘innocent’ investors. This theory implies that HFTs were essentially trying to ‘spoof’ the market, or simply manipulate it. Spoofing is a ‘bait-and-switch’ tactic where a trader places multiple large orders that trigger a market reaction. The trader then proceeds to cancel the orders after the reaction and takes the opposite trade. HFTs took the bulk of the blame during the 2010 flash crash, but some have also suggested that it helped calm things down.
There was also the theory of a ‘fat-finger trade’. This is usually a keyboard error during order placement that results in a larger-than-normal order being inputted and executed in the market. On the day of the 2010 flash crash, several stocks were ‘dumped’ and in particular, there was a large sell order placed on Procter & Gamble that saw the stock shed over 37%. But this theory was later disproved after it was determined that there were sufficient safeguards at the time to prevent such an error and that the decline was a result of a dip in the e-mini S&P futures contracts.
Another plausible theory at the time was technical mishaps at the NYSE, which led to delayed price quotes that consequently inspired panic among market participants. Traders then sought to exit the markets by placing extreme bid and ask prices, while HFTs also attempted to close out positions with large market orders. The result was a cascade effect that eventually led to the flash crash.
The US SEC and CFTC (Commodities Futures Trading Commission), shortly after, embarked on investigations on the actual cause of the flash crash. A report was released in September 2010 that explained the sequence of events that led to the crash. It was said that a large mutual fund (Waddell & Reed Financial Inc.) sold 75,000 e-mini S&P contracts worth over $4.1 billion. The buyers of the contracts included HFTs, which typically do not hold trades for long. The HFTs then started to sell the contracts again, and the combined sales triggered a tumble in the markets as buyers were exhausted.
But the explanation received criticism, especially because it came after over 5 months of investigations into an event that lasted just 5 minutes. This alone proved that the Commissions were running archaic systems. Furthermore, there was nothing wrong with the ‘large’ order because it was consistent with the market sentiment of the day. And it was not particularly a large order because it represented just 1.3% volume of e-mini contracts traded on May 6th and just 9% of volume during the 5-minute flash crash period.
In April 2015, London-based individual trader Navinder Singh Sarao was arrested on allegations that his activities on May 6th, 2010, caused the flash crash. The US Department of Justice accused Sarao of using algorithms that placed large sell e-mini S&P contract orders in the market. He then cancelled the trades and bought contracts at lower market prices. From 2009 to 2015, Sarao and his company made about $40 million using that same market manipulation technique. The legal proceeding took a while to conclude, and it was only in 2020 that Sarao was handed a one-year home confinement sentence. There was no jail time, with prosecutors citing Sarao’s cooperation for the lenient sentence.
Sarao’s indictment did not convince many people. It was hard to imagine that a solitary, low-time trader was responsible for temporarily wiping out the stock market wealth of over $1 trillion. In fact, the revelations of his misdeed raised major concerns about how much worse the big players in the market are capable of doing damage.
Lessons Learned from the 2010 Flash Crash
There are many lessons to be learned from the 2010 flash crash. First, the crash highlighted how the market structure is more complex and interconnected. The crash happened in the equities markets, but it came as a result of large sell orders placed on e-mini contracts on the futures market. This is an illustration of why technology is really a double-edged sword. On one-hand, there’s reduced execution time and costs as well as a quick flow of information. But on the other hand, markets are now interconnected and a mishap or technicality in one market can lead to massive consequences in another.
It took over 5 years to nab one small-time and arguably careless trader in Sarao, but while massive amounts of backup data can be the cause, it really shows how difficult it can be to go after the real pros that are running sophisticated HFT algorithms in the market. Additionally, the SEC and CFTC are not properly equipped to chase after the real big players who are utilising multi-billion technologies to trade the markets.
For investors, the increasing role of HFTs is changing how they engage in trading activity. HFTs trade at incredible speeds, discounting some market information or events in real-time. This has made day trading particularly riskier for investors than in previous years. The use of stop losses has also come into question because traders who did not use the orders were practically unaffected by the crash, but those who used them had to deal with already booked losses. The crash also reminded investors about the risks of taking leveraged trades in the market. A sharp dip in the markets is capable of delivering even more amplified losses for investors.
Flash crashes occur relatively frequently, but the May 2010 crash was significantly notable because of the large tumble in prices as well as massive news coverage. It also brought to the fore the role of HFTs in creating uncertainty and volatility in the markets. While computer algorithms can help boost and maintain liquidity in the markets, they cannot price markets accurately during turmoil. There is a need for a ‘time-out’ during a selloff to ensure that the market is not overwhelmed. This is why market-wide ‘circuit breakers’ were adopted after the crisis. These breakers halt trading in all shares and ETFs when there is a directional move of over 10% in under 5 minutes. There have also been tighter rules for market makers and brokerage firms, while big players are mandated to report on any large orders they intend to place in the markets.
All in all, a flash crash will inevitably happen again. But the lessons learned from the flash crash of 2010 ensure that any new occurrence won’t be as significant, while investors can protect themselves even better.