The Flash Crash Fairy Tale

Two years ago, the stock market crashed in a few minutes, and in almost the same amount of time, it recovered.

The public wanted to know why; how could this have happened?

So the government did what governments do: they filed a report. The official report blamed a securities firm, Waddell & Reed, for dumping too many futures at once and screwing things up.

This is a nice story for the government to tell because it lays the fingers on a known entity. The bad boys at Waddell & Reed screwed up the market.

The government’s story has one small problem — it’s not true. At least not according to Eric Scott Hunsader. Mark Buchanan writes:

The actual crisis struck in the three minutes between 2:41 p.m. and 2:44 p.m., when the market fell another 5 percent to 6 percent. Hunsader’s analysis suggests this plunge was caused by high-frequency traders. They typically act as liquidity providers, standing ready to buy and sell at certain price levels. But the day’s volatility prompted them to dump their holdings to avoid losses. In a matter of minutes, they actively sold an accumulated stock of about 2,000 E-mini contracts. It was this selling, not Waddell & Reed’s passive orders, that caused liquidity to disappear.

There is nothing blameworthy about what the high-frequency traders did. Market makers aren’t charities, and their algorithms were only saving their skins amidst extreme market turbulence. Their actions do, however, rather undermine the common argument that high-frequency traders bring wonderful benefits to the market through the liquidity they provide. That liquidity, as many have pointed out, has a rather ghostly quality and tends to vanish when needed most.

The government’s story boils down to “some big meany came along and harmed our precious market.” They found a culprit and blamed it. That’s what governments do.

The government couldn’t have told us the real reason. So why did the market crash?

The answer is that there’s no answer. It’s just what markets do.

Posted by on May 8th, 2012 at 9:45 am

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