When Markets Crash In A Flash

If you've traded markets like stocks and cryptocurrencies, you'll be quite familiar with crashes. In all cases, we can explain the cause of these events. Furthermore, they take a long time to recover.

Yet, the one type of crash which usually leaves more questions than answers is the mysterious flash crash.

What is a flash crash?

A flash crash is when the price of a financial instrument rapidly drops in value before a quick recovery. The meaning is all in the term: 'flash' describes the speed, while 'crash' describes the decline.

Flash crashes are rare and largely unexplainable events in the markets. While research suggests the influence of computer-driven trading, we are never quite sure of the actual cause. Many experts also point to human malpractice as having a massive impact.

Regardless, the outcome is the loss (or gain) of millions of dollars for traders globally.

What causes a flash crash?

Michael Lewis, the author of The Flash Boys, put it best when he wrote, "People no longer are responsible for what happens in the market because computers make all the decisions,’

Over the past decade, algorithms or computers have become more common when it comes to large-scale trading from affluent individuals and big financial institutions. More specifically, we are referring to HFT (high-frequency trading).

As the name suggests, this is a subset of algorithmic trading where many orders get placed at millisecond quickness with large volume.

One purpose of HFT is to allow exchanges and brokers to perform better and faster order processing. Yet, we often mention HFT when it comes to making quick profits in the markets, courtesy of the speed.

But, HFT is about more than how fast it can transact. It can analyse markets and react to sudden changes in them. For instance, HFT can predict the outcome of a news event by observing historical trends and scanning multiple sources more quickly and efficiently.

While this is good, it is terrible when mixed with an enormous size powerful enough to nose-dive market prices.

A particularly adverse fundamental event or rumour often precedes most flash crashes. In a nutshell, the theme is HFT reacting to something that happened in the news. Then, depending on the severity of said news is what creates a domino effect where one HFT system triggers a sell-off everywhere.

Another trend of flash crashes is how they happen during periods of low liquidity or, in simple terms, when there are fewer participants. This means that any unusually massive order can affect the price.

The gist is that flash crashes result from the reaction of HFT to a news event or a low-liquidity period. However, market manipulation can be at play by spoofing or layering.

These are computer-based manipulative techniques that 'spoof' or 'fake' supply and demand. In simple terms, spoofing is cancelling before execution. Here, the trader places large pending orders to attract one side of participants and terminates these once the market nears that level.

If the pending orders were for longs (buys), those that were 'spoofed' will produce enough volume of trades to drive the price to an extreme high. This point represents a nice area for the spoofer to sell as the market recovers back to previous lows (the opposite is true if the pending orders were for shorts or selling).

Layering is an advanced form of spoofing where the trader 'layers' massive orders at several close-by price levels. This causes the spread's midpoint to move away, allowing the trader to execute positions in the opposite direction.

And then the final alleged or potential cause of a flash crash is the fat-finger error.

As dumb as it sounds, reporters have noted many instances of this happening over the years. The fat-finger error is a supposed misclick by a keyboard or mouse in a financial market where the executed order is far larger than intended. This demonstrates that volume is one of the main factors in flash crashes.

Most popular examples of flash crashes in recent history

Now let's look at the well-known flash crashes.

• May 2010 US stock indices flash crash ('Crash of 2:45')

This is the first highly publicised flash crash that happened around 2:45 EDT on 06 May 2010, lasting 36 minutes. It affected several stock indices like the S&P 500 and Dow Jones Industrial Average, which fell, on average, by 10% before recovery.

Almost five years later, they arrested a trader named Navinder Sarao in 2015, partly accused of spoofing orders worth about $200 million. Yet, the use of HFT by other firms was also blamed.

• January 2015 Swiss franc flash crash ('Frankenshock')

This crash is the perfect example of a rare, adverse news event being the primary catalyst. The 'Frankenshock' involves the Swiss franc and how the Swiss National Bank (SNB) fixed this currency against the euro at 1.2.

The purpose was to cheapen exports between Switzerland and Europe. Yet, before the rash, the SNB printed too many Swiss francs, which angered citizens. This led to talks of the peg being scrapped, which eventually happened in the early morning of 15 January 2015.

The market reacted on the spot, sending all CHF pairs, including EUR/CHF, into sudden drops and rallies. For instance, USD/CHF dropped almost 19% in a few minutes. But, as expected, all the CHF markets recovered over time.

• June 2017 Ethereum flash crash

This crash is the most dramatic when looking at the size of the fall, even though it only affected one platform. It happened to Ethereum at the Coinbase-owned GDAX exchange (now Coinbase Pro) on 22 June 2017. The drop was almost 100% from $320 to $0.10.

According to GDAX, this was due to a multimillion sell order which first caused the price to drop to $224. At this point, 800 stop loss orders and liquidations happened, plummeting the price even further to 10 cents.

• May 2022 European stock indices flash crash

This most recent major flash crash affected several European-based indices like the Swedish OMXS30 and the German DAX, among others. This happened on 02 May 2022, lasting five minutes from 09h56 to 10h01 CET.

The drops across the European indices ranged from 1.6% to 6.8% before the expected rebounds. After speculation, research confirmed that Citigroup was the primary offender due to the so-called fat-finger error at their London trading desk.

Final thoughts

So, why are flash crashes so mysterious? Many contrarian experts believe that these are planned attacks for a 'quick buck' - and there's some sense in this. Because it is illegal, the media can present an elaborate story of the cause to hide the true intentions.

In reality, it is very profitable for large financial institutions to orchestrate such events. It's all about self-interest. Sadly, the fines they may receive are pocket change because they are too big to punish.

The main takeaway is that trading any financial market comes with such risks, meaning you should always be prepared.