The largest intraday swings (after 1987) in the DJ Index have all happened in the subprime crisis era. More precisely, the DJ Index has stumbled 10% or more four times in October 2008, with the largest intraday swing of 12% on 10th October 2008. If we were to take the top ten intraday swings, nine of them have occurred during the period October to December 2008 and one in May 2010. The average swing has been around 9.8%, with the range of swings varying from 8.4% to 12.1%.
In percentage terms, the May 2010 fall ranks as the sixth largest swing in the DJ Index since 1987. This is an unusually large move, but perhaps more interesting would the underlying reasons for such swings.
In theory, financial markets are supposed to reflect the macro economic conditions as well as be informationally efficient. Post the Lehman crisis, financial markets conditions were unusually turbulent and reflected the bouts of sudden pessimism and optimism. To a large extent, these swings are understandable, as speculators and investors rushed into the markets to adjust to the changing circumstances during the period October 2008 to December 2008.
There is another type of problem that can cause these major swings: in trader talk this is dubbed as a fat finger problem. This is defined as an error made while inputting text via keyboard, despite the fact that the user knows exactly what to type in. This usually results from the operator's inexperience at keyboarding, rushing, not paying attention, or carelessness. So if the trader was wanting to sell one million shares, but punches in three extra zeros, the sell order is for one billion. This kind of problem is evident elsewhere– for example when you write a check for one million dollars, you may go wrong on the number of zeros, but the amount stated in words works as a control.
The problem of fat fingers is accentuated by the advent of electronic trading systems in which computers have taken over the function of traders and execute orders in microseconds. Today’s stock markets are overwhelmingly governed by mathematical algorithms programmed to jump in and out of markets at the speed of light in frenzied search of trades that yield a quick profit. The global investment banks have built trading software which can spot price aberrations and execute trades much faster than a trader. This has given rise to the algo trader who uses technology and sophisticated programmes to spot trading opportunities. For example, less than 35% of the trading in NYSE shares actually takes place on the NYSE itself, but on a plethora of other platforms including dark pools and systems operated by brokers themselves.
While algo traders no doubt boost market volumes and increased liquidity, there is also a downside. It is unclear whether brokers and stock markets have the risk management systems to guard against algos running wild perhaps triggered by erroneous fat fingers trades. The problem in stock markets quickly gets translated into bond, and currency markets which are supposed to be interlinked on the same computer systems– this raises the spectre of a systemic hit to the financial system.
The regulatory concerns stem from the fact these massive volatilites spooks ordinary investors out of the markets, but benefits high frequency traders. The impact of a market panic at a time when the US economy is slowly coming out of a recession cannot be understated.
There are other theories that the market fall was the result of a cyber terrorist attack in which the terrorists have targeted financial markets at a time when markets were wary of a double dip recession. Remember, that the flash crash occurred at a time when markets were unusually nervous about the outcomes of the sovereign debt crisis in the Eurozone. This lends credence to a suspicion that perhaps some market manipulation was at work, and some traders /hedge funds were perhaps trying to create a bear market so that they could take advantage of the Fear Premium which was already present in the market.
Whatever the cause, the worrying factor is the question whether the markets have outpaced the ability of the infrastructure to handle such situations. A parallel can be drawn with the use of derivative instruments whose use mushroomed over the last two decades without comprehensive oversight. Only after billions of dollars of losses and a systemic crisis has the attention shifted to transparency and tougher regulations.
