No Easy Tech Explanation for What Caused Wall St. 'Flash Crash'

On May 6, the Dow Jones Industrial average was puttering along, trading in a range between 10,600 and 10,800 for most of the day. Then, suddenly around 2:30 pm, the index suddenly dropped 1,000 points in just a few minutes. Panic dulled, and the index perked right back up. But for a few minutes there, half a trillion dollars worth of value had been erased. The incident became known as "the flash crash.". 

Regulators, investors, and the public all asked the same question, "WTF?!?" How could our vaunted markets be so brittle? Did anyone know what the hell was going on? All kinds of hypotheses were floated. Hackers! A buggy automated trading program! Something more sinister! No one knew quite what happened, but it was clear that computers trading stocks had something to do with it. 

Several government bodies started investigations, including a joint effort between the Securities and Exchange Commission and the Commodities Futures Trading Commission. Of course, everyone was looking for a scapegoat, someone or something to blame. But the latter organization also took steps to address the deeper problems of our markets increasingly being driven by algorithmic, computerized trading. 

The CFTC created a Technology Advisory Committee made up of quantitiatve traders and other experts, which met for the first time today. Shockingly, it had been five years since the CFTC had such a board. And it's exactly during that time when algorithmic trading really came to the fore.

 "The past decade of fragmentation and automation has given rise to a whole new type of professional trading firm: one that uses sophisticated computer algorithms, often running on servers housed right next to exchanges' own machines, and high-speed market data feeds to buy and sell securities in rapid-fire fashion," wrote Michael Peltz in an in-depth investigation of algorithmic trading for Institutional Investor in June. "Some of these high frequency traders place hundreds of millions, even billions, of buy and sell orders a day, continually canceling and replacing them, and are likely to be on the other side of your trade. Not that you'd know who they are -- proprietary trading firms are not required to disclose their identity -- or recognize their names."

We'll be tracking that advisory committee as they go about their work, but what was the first substantive item on their agenda? The flash crash. And the saddest thing is that there is still no clear culprit in the case. 

"It was not a fat finger. It was not a hacker. It was not an algo gone wild," said Richard Gorelick CEO of RGM Advisors, one of those unnamed but important a high-frequency trading firms.

So if it wasn't one of those things, what was it? Gorelick didn't exactly point the finger at anything specific, so much as at complexity itself. 

"Complex systems like markets fail in very complex ways. They do not fail in simple ways because the simple ways have been thought of," Gorelick said. "We see this not only in markets but in oil rigs and plane crashes. There is usually a cascading effect of multiple factors that were at fault."

Among the multiple factors were "real human panic" over the situation in Europe (i.e. Greece), problems at equity firms keeping up with the volume of trades, and slow responses from the stock exchanges. 

If you want to see Gorelick's whole presentation is available online. And like I said, this is an area that we'll be reporting on more and more here on the tech channel.