Post Mortem on the Flash Crash


The scribes are rehashing the events of last May, the Flash Crash.   If you were under a rock, the market plummeted like a anchor in the ocean in a matter of seconds. Billions in equity were wiped out in minutes.  Great companies like Accenture were trading for pennies on the dollar.

The fixes that have been proposed may or may not work.  Essentially what SEC regulated exchanges are doing is putting in circuit breakers on individual stocks.

After the crash of 1987, exchanges put in market wide circuit breakers to stop the market at certain percentage points as it dropped in value.  They worked.  But the market was far different then. It was a human market with technological interaction.  Volume was concentrated at the NYSE and NASDAQ.  Investment banks were basically private partnerships and not playing with the public’s money.  The exchanges themselves were mutual non-profit entities.

Today, the market is far different than it was even five years ago.  It is not a human market anymore, but a technological market.  Volume instead of being traded in a central place is fragmented across a growing supply of dark pools. High Frequency Traders employ technological strategies to confuse the market.  Quote stuffing is what it is called.  Payment for order flow didn’t exist.

Markets always evolve.  Governments rarely keep pace with the changes.  Exchanges are on the front line of change, and adapt much quicker today than they used to since they are publicly traded and have a profit motive.  Evolution is not a bad or good thing, but it is important to recognize how the evolution affects the market.

The most sacred thing in a market is a transparent price. Currently on the SEC side of the markets, price is nowhere near transparent.  The publicly quoted prices the public sees on the tape are not where the real market is-the real market is in the back rooms of investment banks and in the dark pools proliferating across the industry.  Nothing that the SEC did to prevent the flash crash from happening again made prices more transparent.

During the flash crash, no one could figure out a price on the SEC regulated side of the business. In many stocks, there were bid prices higher than offer prices.  The market moved so fast, and was so fragmented, arbitrageurs could not step in.

The scions on Wall Street want the dark pool model to persist. They make a lot of money by having dark pools.  If you think they make money in stocks, check out what they make in the non-transparent corporate and muni bond markets!  Just a tip, before US Treasury futures were introduced in 1973 at the CBOT, the spread was 15/32 0r $468.75 on a $100,000 bond.  After the futures market interjected transparency into the market, the spread narrowed to 1/32 or $31.25! Dark pools in stocks don’t rip off customers as blatently as that, but they do give a manufactured edge to the people that run them.

The things that need to happen for markets to work more efficiently and competitively are these:

1.  End dark pools. Force everything to a regulated exchange. There can be a proliferation of regulated exchanges, but at least everyone can participate and bid/ask spreads will be public.

2.  End payment for order flow.

3.  Stop the practice of quote stuffing by HFT traders.

4.  Keep Circuit breakers (but ending the other practices will make them less relevant)

5.  Exchanges also need to publish volumes and quotes within seconds of the trade happening.  More information makes for better markets.

I want to be clear that I am not against changes in the market, or changes in the way traders interact with the market.  But at the same time we need to be cognizant of how these evolutions change the way the market works.  The critical thing is to get the market working at a highly competitive and efficient rate so that it works the best for the public.  Today it doesn’t.


The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.

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