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What Really Caused the Flash Crash

AP

Here's some good news: it's the anniversary of the Flash Crash and we know what caused it.

Many things that happen in financial markets remain mysteries for perpetuity. The causes of the housing boom and bust, for instance, are still debated by economists. Was it the Fed's loose money? Deregulation in banking? Perverse pay incentives? Government housing policy? We'll be debating this forever.

But the Flash Crash is different. We know how it happened.

Here's the basic outline of what caused the biggest one-day point decline in the history of the Dow Jones Industrial Average. On May 6, 2010, the primary market makers in the stock market just stopped automatically taking the other side of everyone else's trades. This made the market extremely illiquid. Sell orders had no immediate bids, which basically meant the market became a bottomless pit for a few minutes.

A brief history might help to explain this. In the old days, important stocks were monitored by so-called "specialists" who worked on the trading floors of the stock exchanges. They were charged with keeping the market "orderly." This meant they would temporarily take the other side of trades when unmatched orders to buy or sell came in.

The government hated these guys. It was constantly accusing them of cheating investors in one way or another. The policy makers did everything they could to wipe out the specialists, replacing them with computers.

As a result of the government's war on specialists, much of liquidity in the market now comes from high-frequency trading computers. Let's call them High Freaks. These things can execute trades at the speed of light.

Mainly, they make money by executing an enormous volume of trades around small price points. You sell for one dollar, they buy for a dollar and one tenth of a cent. They they sell for a dollar and two tenths of a cent. Do that often enough and you're talking real money.

Flash Crash: One Year Later - A CNBC Special Report
Flash Crash: One Year Later - A CNBC Special Report

Last May, this system broke down. Why? Well, if well-informed traders come into the market, they can make life hell for the High Freaks. At some points in a market cycle, trading becomes less random and more rational.

Actively managed hedge funds love this because it means they can make a lot of money. The High Freaks hate this because it can make markets very costly for them. They need markets to be more or less random to make money.

In May last year, the smart traders were devastating the High Freaks. And so the High Freaks did the smart thing: they stopped trading. Instead of losing money by taking the opposite side of trades made by well-informed traders, they pulled out and waited for the markets to become random again.

As it turns out, markets can be very volatile without the specialists and without the High Freaks. Now we understand this. Too bad we didn't think too much about it before we launched the war on the specialists.

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