This article points out the components that have caused a change in the factors that form the definition of the phrase "Flash Crash". No doubt technological developments have been a major factor in making Flash Crashes more prevalent. Another interesting thing to note would be that while recessions typically take several years to form before there is a correction of this behavior, flash crashes are typically unexpected.
Flash Crash Vs Recession
To properly understanding the metamorphosis of the phrase flash crash, it is important to first understand the difference between a flash crash and a recession. A recession is defined as a period of temporary economic decline during which trade and industrial activity are reduced, generally defined for a fall in Gross Domestic Product over two quarters.
A flash crash, on the other hand, is defined as an event in electronic securities markets wherein the withdrawal of stock orders brings about a rapid reduction in prices.
When one considers these two definitions, it is clear that the first market phenomenon, recessions, are typically grounded in factors of production not being as efficient as they could be when compared to when they are used more optimally. A Flash Crash, however, refers to a market phenomenon linked to trading activity, with none of the phenomena coming from underlying economic factors. The comparison of these two definitions might seem trivial at first, but that is because during the early usages of the phase flash crash, it seemed to be very much like a recession!
The First Flash Crash
In 1961, stocks in the United States had risen 27% in a continued rally that had been ongoing since the great depression of 1929. Some market pundits attribute this decline to complacency among investors. If so, it is understandable as to why this was the case. Without a significant decline in the value of stocks for round about 30 years, it's hard to imagine who would not be complacent under such a market climate!
More than anything, however, it seems that the media ran with the phrase Flash Crash to avoid a panic in the market which would have inspired a selloff in stocks. The use of the word seems to be more rooted in this explanation. Using the word recession might have frightened some investors into acting against their best interests. If not this, there would be no other apparent reason why this was the case. The decline in prices from December 1961 to June 1962 fits perfectly the definition of a technical recession!
Contemporary Flash Crashes
In more recent times, Flash Crashes last for much briefer periods, considering the entire decline and rebound in prices. For the sake of illustration, one might consider the 2010 Flash Crash which was caused by the spoofing of bid prices of Exchange Traded Funds in American markets. The US market crashed and was unavailable for a total of 36 minutes! Juxtaposed to the first Flash Crash, which occurred in 1962 and lasted 6 months, it is clear that the time variable that forms part of the definition of Flash Crash has decreased dramatically since then!
Another more recent illustration of a Flash Crash would be the Pounds Flash Crash in 2016, which was said to be caused by an overreaction by algorithmic trading strategies to negative sentiment regarding Brexit. The pound declined to its lowest value since 1985 and subsequently recovered these losses, all in a period no greater than 2 minutes! Another illustration for a change in the definition of the Flash Crash.
A final Illustration of the contemporary flash crash is sourced from the Singapore Stock Exchange. In this particular scenario, shares of Jardine Matheson crashed by 83 percent minutes after the Singapore Stock Exchanged opened before rebounding throughout the day. As a result of this occurrence, rules for trading on the Singaporean Stock Exchange have subsequently been changed.
Concluding Remarks
It is clear from the events described above that there has been a time shift in how markets operate when compared to the first time the phrase Flash Crash was used. There has been a growth in both algorithmic trading and high-frequency trading, which have allowed for more rapid execution of market orders, and thus greater fluctuation of security prices. Market participants need to explicitly take such occurrences into account when planning their investment or speculative positions. As algorithmic trading continues to grow in importance, market participants need to find ways to protect themselves for when these systems do not function as expected or when they are manipulated to act against their instructions. Hedging needs to move away from just considering the calculation of metrics like VaR and include metrics that quantify the probability of Flash Crashes occurring, whatever they may look like. Such efforts will keep or push markets towards the efficiency they claim is inherently theirs.
Complement the article with the following video
References
Kennedy Slide of 1962, Wikipedia.com
Back to the Future, jasonzweig.com
2010 Flash Crash, Wikipedia.com
Flash Crash of the Pound Baffles Traders, bloomberg.com
$41 Billion Flash Crash in Singapore, bloomberg.com
Value-at-Risk, corporatefinanceinstitute.com
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