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In today’s complex electronic markets, we need an automated and appropriately calibrated way to pause or limit trading if prices move too far too fast.
US Securities and Exchange Commission (SEC) Chair, Mary Schapiro (SEC, 2015).
1. “Flash crash”
Equity investors and traders in the US stock exchanges watched in shock when the “Flash Crash” occurred on the New York Stock Exchange (NYSE) on May 6, 2010. At 2:42 p.m., the Dow Jones Industrial Average (Dow) was down more than 300 points; the index then started to fall at faster speeds. In the next 5 min, it lost more than 600 points. By 2:47 p.m., the Dow had dropped almost 1,000 points for the day (998.5 points). It was the biggest one-day point decline in the history of the Dow (Easley et al., 2010). Twenty minutes later, at 3:07 p.m., the market regained the majority of the 600-point drop (Lauricella, 2010). This involved an initial high-selling speed, followed by a high buying speed during the V-shaped rebound that occurred within minutes. The market was thus very volatile. As a result of this dramatic process, many were left wondering what caused, and what exacerbated, this Flash Crash.
The regulators’ investigation points to high-frequency trading (HFT) as the cause of the Flash Crash (Commodity Futures Trading Commission (CFTC) and Securities and Exchange Commission (SEC) joint report, 2010). Some researchers support this view (Cardella et al., 2010; Easley et al., 2013), while others recognize that HFT exacerbated market volatility, but do not believe that the HFT was the trigger of the Flash Crash (Kirilenko et al., 2014).
The arrest of Navinder Singh Sarao, a London-based futures trader, on April 21, 2015 may provide a final clue. The main allegations by the US Department of Justice include market manipulation such as “spoofing” – a practice of bidding or offering with the intent to cancel the bid or offer before execution. Sarao’s implementation of computerized high-speed dynamic spoofing – by placing and quickly cancelling large sell orders in E-mini contracts at different prices – might have been the first trigger of the Flash Crash (DoJ, 2015). Following this, executed sell orders by numerous HFT and non-HFT traders drove the rapid fall of the Dow. After a...