Flash Crash Threatens to Return With a Vengeance

What should investors watch in 2012? As the new year dawns, there are plenty of short-term issues on the horizon, ranging from the eurozone to fiscal gridlock in the US to upheavals in the Middle East.

But amid that list there is also another, often ignored, question to ponder: could 2012 produce a repeat of the “flash crash”, the bizarre episode that hit the U.S. equity markets back on May 6 2010?

Think about it for a moment. A full 18 months have passed since the strange episode that caused the Dow Jones

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[.DJI  Loading...      ()   ] to tumble 650 points in half an hour, wiping $850 billion off share prices, before rebounding. Since then, the issue has faded from view amid the eurozone drama.

But to this day, nobody has fully explained what really happened on May 6. Nor is there any evidence that the fundamental problems that caused the flash crash have been resolved. That leaves some scientists fearing that not only is a repeat of that flash crash possible, but it is probable — and next time round, it could be even more damaging.

To understand this, take a look at a fascinating transatlantic research paper published by the Bank for International Settlements. One of the paper’s co-authors is Dave Cliff, formerly a financial trader who now runs the UK government’s Large-Scale Complex Information Technology Systems project, an endeavour that analyses the risks of IT systems in sectors including healthcare, nuclear energy and finance. The other, Linda Northrop, runs a similar project at Carnegie Mellon University, which was initiated a decade ago by the US military.

In recent years, these two teams have used engineering and science skills to analyse what they call socio-technical risks, or the dangers that occur whenever complex technological systems proliferate, creating “systems of systems” that nobody understands. In early 2010, well before May 6, they released a brilliantly prescient report that predicted that a systems failure loomed.

Since then, they have continued their research, with sobering conclusions. Most notably, these researchers believe that the flash crash was not an isolated event; on the contrary, it was entirely predictable given how IT systems have proliferated to create a system of systems that is now interacting in unpredictable ways that regulators and investors cannot comprehend, far less control.

Usually, this danger is not visible to investors. After all, markets generally work well, leaving financiers in the grip of a phenomenon that Diane Vaughan, the sociologist, called the “normalcy of deviance” (based on her work on the Challenger 1987 space shuttle disaster): because people have sailed close to the wind and survived, they assume they can continue to do this — and turn a blind eye to anything that seems uncomfortably bizarre.

But the risks and near misses are rising all the time. Take May 2010. At the time, the wild gyrations in prices were deemed shocking. However, Cliff and Northrop think it could have been dramatically worse: if the systems failure had been a little later that day, prices would not have had a chance to recover before the US market’s close, which would have caused carnage when Asian

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[.N225  Loading...      ()   ] and European markets

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[.FTEU3  Loading...      ()   ] opened.

“The true nightmare scenario would have been if the crash’s 600-point down-spike, the trillion-dollar write-off, had occurred immediately before [US] market close,” they note. “The only reason that this sequence of events was not triggered was down to mere lucky timing. . . the world’s financial system dodged a bullet.”

And such luck may not be repeated. Since May 6, there has been a series of other, mini flash crashes in commodity markets. While regulators claim that introducing trading limits will fix the issue, there is scant evidence that this will really work, given the scale of this technological innovation.

Is there any solution? Cliff and Northrop offer one idea that might help: regulators and bankers should replicate what some scientists have done elsewhere and join forces to create a cross-border computing centre that is capable of extremely advanced, large-scale financial simulation. Their idea is that this would essentially replicate what is done in meteorology or complex engineering to map the markets — creating the equivalent of wind tunnels to test new financial products and ideas, and warn of looming trouble.

It sounds pretty sensible to me. There is even an obvious platform for this: the U.S. is currently creating an Office of Financial Research, which could host such a device. But don’t hold your breath; sadly, the OFR is floundering in its efforts to define its role, and most regulators still prefer to forget May 6 rather than admit in public that they are struggling to understand how modern markets really work. And that, sadly, is unlikely to change, unless there is another flash crash. It is not a comforting thought; least of all given all that is happening in the eurozone.