Lessons From the Algorithm-Fueled May 6 Flash Crash

What's needed: more human oversight, less artificial intelligence

This article is from the archive of our partner .

On May 6, the Dow plunged 1,000 points in less than half an hour. By the closing bell, the market had recovered to close about 3 percent down on the day, but investors, naturally, wanted to know why the "flash crash" had happened. Now, a new report from the Securities and Exchange Commission and Commodity Futures Trading Commission offers an answer: an automated trading algorithm sold off its company's contracts too quickly, leading to a snowball effect that launched a panic.

  • How It Happened  According to the SEC-CFTC report, the algorithm in question was designed to sell based only on market volume, not based on price or time. As a result, when the program took effect on May 6 "against a backdrop of negative market sentiment and thinning liquidity," it "executed the sell program extremely rapidly in just 20 minutes," touching off a full-scale market disruption. The report doesn't name the company whose algorithm set off the flash crash, but it's believed to be Waddell & Reed, a financial planning company based in Kansas.
  • Hedging Strategies Aren't Reliable  James Hamilton at Econbrowser points out that the sudden plunge exposes market vulnerabilities we usually ignore. "This episode serves as another reminder, as if we did not have enough already from the financial fireworks in the fall of 2008, that the faith many market participants have in their hedging strategies is misplaced," he writes. "Aggregate risks cannot be hedged by the aggregate market ... It also should remind us that it can be a really stupid plan to sell regardless of the price. And it is still a really stupid plan even if it comes out of what somebody told you is supposed to be a very smart computer algorithm."
  • Preventing Future Crashes  The Atlantic's Alexis Madrigal notes that some market implosions are caused by "bad actors", but "simple incompetence... is a harder thing to regulate against." Still, there are options: Madrigal quotes the CFTC's John Bates on the need for "better pre-trade back-testing" of strategies like the runaway algorithm, and "better real-time monitoring of the trading process, using technology that is available but underused."
  • The Fallout: Less Trust Than Ever  At MarketWatch, Nick Godt writes that the market has become a riskier place in recent years, and "big periods of volatility, as took place in May... have been increasingly common and are likely to continue." He concludes that "the funny feeling surrounding computer trading and its ensuing controversy, perhaps, is the uselessness of the system at the moment. It's the big guys playing against each other and tripping over their highly efficient computerized trading programs — and they're the ones getting hurt."
  • A Failure to Communicate  David Warsh, of the blog Economic Principals, sees the May 6 crash as indicative of a wider erosion of "civic liquidity" -- the simple give-and-take among reasonable people that keeps political discourse civil and Internet discussions flame-free. "The fragmented world of financial markets may be the lesser danger," he warns. "Intransigence, the breakdown of political back-and-forth, probably is the greater threat."
  • Blame the Terminator!  The Big Picture's Barry Ritholtz looks at contemporary markets and sees "a system without humans charged with maintaining orderly markets, with software bots swapping shares with other silicon-based life forms." It puts him in mind of Skynet, the self-aware computer network from James Cameron's Terminator franchise. "Instead of putting SKYnet in charge of national defense, we have put it in charge of our markets and economy," Ritholtz writes. "The end result — minus the spectacular special effects — seems to have been the same."

This article is from the archive of our partner The Wire.