Flash crashes in financial markets are causing increasing consternation among central bankers, traders and indeed anyone who depends on the great many things that are priced by markets. In early December, the Bank of England’s Prudential Regulatory Authority published its report on October’s flash crash in sterling. In the early hours of 7th October, the value of the pound fell 9 per cent, a slide that occurred in just 40 seconds. This was just the latest in a series of flash crashes. The first took place on 10th May 2010 when during just 36 minutes, US stocks lost $1 trillion of value before largely recovering.
Many politicians, prosecutors and journalists believe in the “Bad Apple” theory, in which these events can be traced to the actions of rogue individuals. After the first flash crash, they set off in pursuit of the evil-doers. Five years later, their chase ended at the door of a semi-detached house in Hounslow, west London where a 36-year-old man, Navinder Sarao, traded stock futures on the internet. Similarly, Bank of England investigators believe that sterling’s October flash crash was caused by a lone trader working for Citibank in Tokyo.
Sarao was extradited to the US and pleaded guilty to two of the counts he was charged with in November. But some have questioned whether he was solely responsible for the flash crash. And the scale of the allegations against single traders does not sit well with regulators’ claims that, after several years of toil, they have delivered a more robust and resilient financial system.
Flash crashes are not only more frequent but they are occurring in markets where stability is both expected and critical to the smooth function of market economies. The German government bond market, which is the base for determining the interest rate payable for debt in Europe, experienced a flash crash on 15th January 2015. Outside of Europe, more financial contracts derive their price from the US government bond market than from any other, but even the Treasury market proved susceptible to a flash crash on 15th October 2014.
Why do flash crashes happen and what can we do about it? Let’s start with how financial market function. People own assets, such as a home…