Chicago markets can't allow another flash crash (but they probably will)
SCOTT NATIONS
Getty Images/Stocktrek Images
In the early evening of July 6, silver futures were trading for $16.14 an ounce on the CME's Nymex exchange. A few moments later they plunged more than 10 percent, to $14.34 an ounce. Then, almost immediately, they regained nearly all the loss to trade at $15.95.
Investors and speculators have been trading silver and gold for centuries. Less than 50 years ago, the introduction of futures contracts on gold and silver made speculating in precious metals easier. More recently, trading moved away from open-outcry pits to computer servers producing no more than a gentle hum. The computer made trading incredibly efficient; trading volumes have exploded as trading floors, where potential volume is limited by the number of traders who could cram themselves into the space, gave way to computers, where volume is limited only by the speed of light. But the advances in speed and volume come at a price.
On July 6, in the sort of episode that has become too common and which is strictly limited to electronic markets, the silver market experienced a "flash crash" when it inexplicably collapsed under a deluge of selling and then swiftly recovered.
Flash crashes threaten futures markets for all types of assets, and they continue despite that danger. In June we had a minor flash crash in gold futures. In October 2014 we had a flash crash in the Treasury futures market. And on May 6, 2010, a reckless hedger using an even more recklessly programmed algorithm caused the crash that gave the phenomenon its name when they pushed the Dow Jones Industrial Average down more than 7 percent in just a few minutes. At the bottom the Dow had lost nearly 10 percent in a single day.
In my recent book, "A History of the United States in Five Crashes," I point out that this original flash crash was noticeably different from previous stock market crashes. This time humans weren't in charge. And while humans launched the algorithm that did all the damage, it was the manner in which other algorithms responded that left the computers believing our markets offered unlimited liquidity. When they tried to take advantage of that illusory liquidity, they pushed the market to its breaking point.
Chicago's futures exchanges have enjoyed an "if we make it electronic, algorithms will trade it" mindset that is both a change from the analog days and an echo of those days when more trading was undeniably better. Chicago's exchanges need to recognize that volume isn't good if it comes at the cost of repeated flash crashes.
It's not just money that is lost in flash crashes; they erode confidence in the underlying markets, too. Who wants to invest in even a blue chip stock like Accenture if it can fall to $0.01 a share like it did in that 2010 flash crash because some knucklehead programs an algorithm recklessly? Who can trust a market like Treasury futures if the 2014 flash crash can result in 11.5 percent of all trading in the 10-year Treasury futures being done by high-frequency traders simultaneously buying and selling their own orders?
Flash crashes won't stop until exchanges make them too expensive for those responsible for them. In 2010 our stock market crashed because one institutional trader stripped all the price and time safeguards from its algorithm; the trader wouldn't have done that if the cost were something more punishing than just selling at disadvantageous prices. If the culpable party were denied access to markets until it could certify​ its faulty code had been fixed, it's more likely the trader would act more responsibly. This is the first step to a solution.
Algorithmic traders have a duty to understand how their systems will react. The exchanges have a duty to make certain they fulfill that responsibility.
Scott Nations is president of NationsShares, an options investment firm, as well as a contributor to CNBC and author of "A History of the United States in Five Crashes."
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