Crashes tend to have common features.
Liquidity, fear and large positions against an asset are some of them. Lately, however, a lot of it has been due to computers and an increasing number of derivative products that allow leveraged bets. Unless regulators start taking a serious look at the rise of machines in marketplaces, flash crashes will become more common. Adding some oversight to unregulated and highly geared markets might be a good idea also.
Today's sudden drop in the British pound serves as the latest warning that computers can be great to increase speed, but they're dumb. All they do is follow orders. If they're told to sell given a certain set of circumstances, they keep on selling, even if the logical thing to do is stop. What's worse is the fact there aren't that many smart people to write computer-trading programs or design new trading models on which to base them. That means a whole lot of computers work with only a handful of strategies. Any moves are exacerbated simply because everyone is doing the same thing.
It's no coincidence that the frequency of crashes and bubbles has risen exponentially over the past 30 years, as pointed out by the late Charles P. Kindleberger in his book Manias, Panics and Crashes. A quick look back confirms that. The stock market flash crash on May 6, 2010 in the U.S. was largely attributable to computers' reactions to sell orders in S&P futures contracts.
Herd behavior was already bringing markets to their knees even before machines were so prevalent. When Long-Term Capital Management collapsed in 1998, part of the reason the sell-off in sovereign bonds accelerated was that many other funds and even bank proprietary desks were pursuing the same strategy. What in the late 1990s was a handful of people trading has evolved into thousands of computers running mathematical models that are mostly similar. It's bound to crash at some point.
That's especially true in foreign exchange. The $4.1 trillion a day market is traded almost entirely over the counter and about two-thirds of activity happens in swaps, meaning leveraged bets rule. Add a currency that's being widely shorted, like the British pound, to the Molotov cocktail and it only takes one wrong trade when liquidity's low for things to run amok.
Too much regulation is bad, but good rules and enforcement have a place. If authorities need any more reason to start scrutinizing the role of computers in markets, today's flash crash was it.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
(Corrects erroneous reference to options in sixth paragraph.)
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