Investors may need to get used to flash crashes

The recent overnight crash in sterling, which saw the currency plunge by more than 6 per cent in a matter of minutes before swiftly rebounding, is the latest in an increasingly long line of so-called flash crashes to afflict financial markets.

Sterling’s precipitous decline was less severe than that seen on June 24th, in the wake of the shock Brexit referendum result. Nor was it nearly as marked as the January 2015 shock which saw the Swiss franc soar higher by 30 per cent after the Swiss National Bank announced it would no longer hold the currency at a fixed exchange rate with the euro. However, both events had obvious fundamental triggers; a “natural market resetting”, JPMorgan strategists cautioned recently, is not nearly as “problematic” as a disorderly decline triggered by order flow issues.

Sterling is stuck in a well-documented downtrend and sentiment was not helped by French president François Hollande’s warning that Europe should take a “firm” stance with the UK regarding Brexit negotiations. Still, most strategists agree market liquidity and order flow issues played a large part in sterling’s flash crash. Intra-day currency market moves are typically modest, and Hollande’s words alone would not normally trigger such a rapid collapse in the world’s fourth-most traded currency.

Vulnerabilities

Some $5 trillion (€4.5 trillion) is traded daily in the foreign exchange market, which has long been perceived to be much more liquid (liquidity refers to the ease with which assets can be bought or sold without impacting prices) than equity markets. Nevertheless, JPMorgan warns of “liquidity vulnerabilities”, and currency flash crashes – extreme market moves in extremely short timeframes – certainly appear increasingly common. In January, the South African rand plummeted 9 per cent against the dollar in just 15 minutes, before swiftly rebounding. In August 2015, the New Zealand dollar suffered its largest intra-day drop in 30 years during another short-lived plunge. Like the aforementioned sterling and rand flash crashes, the move took place in the thinly traded overnight session, with the dramatic widening in bid-ask spreads testifying to the part played by market illiquidity in market flash crashes.

The most infamous flash crash of recent years occurred in May 2010, when US indices plunged 9 per cent – their biggest intraday loss since Black Monday in October 1987. The bulk of those losses occurred over a five-minute period, with markets then quickly recovering lost ground. During that brief period of market mayhem, more than 300 stocks and exchange-traded funds (ETFs) fell by over 60 per cent, with some trades executed at a penny or less. Stock exchanges subsequently cancelled more than 20,000 trades, although many trade executions that took place at artificially low levels were allowed to stand.

ETF chaos

Market reforms, such as temporary trading halts in individual stocks following especially swift downdrafts, were initiated in the aftermath of the crash. However, those safeguards have not erased structural vulnerabilities, as evidenced by the volatility seen on August 24th, 2015. China-induced worries saw some $1.2 trillion (€1.1 trillion) briefly wiped off US shares, with the bulk of those losses recovered within 15 minutes. ETF trading was particularly crazed, many being hit with enormous losses that bore no reflection to their underlying value. One ETF tracking the S&P 500, for example, fell by as much as 26 per cent in the opening minutes of trading, compared to a fall of 5 per cent for the actual index. Another ETF tracking the least volatile S&P 500 stocks fell by as much as 46 per cent.

Bond markets, too, are not immune to flash crashes. In October 2014, US government bond yields plummeted on little news only to completely recover within 12 minutes. It was one of the largest intra-day moves of the last two decades, the key difference being that previous large swings were triggered by important policy announcements.

The growth of high-frequency trading (HFT) is often blamed for such episodes, although defenders of the practice note that flash crashes are not a new phenomenon. The forgotten flash crash of 1962, for example, bears a notable resemblance to more recent market scares. Tumbling prices spooked investors, causing liquidity to dry up as buyers steered clear, resulting in a dramatic widening in bid-ask spreads and acceleration in chaotic price declines.

Increased fragility

Clearly, fast, messy markets are not a new development. Liquidity has always had a habit of drying up just when it is most needed, as panicked traders step aside rather than trying to catch a falling knife. Still, the “frequency and amplitude of outsized volatility events” has increased, cautions Bank of America Merrill Lynch. “Market fragility is increasing as phantom liquidity creates the illusion of stability,” warned Merrill in a note released just days before the recent sterling flash crash, with currency trades now having a 60 per cent bigger impact on price than comparably sized trades did just two years ago.

Many strategists warn that banks, wary of taking risk onto their books due to stringent regulatory measures introduced in recent years, are increasingly withdrawing from the currency markets. The five largest global banks accounted for 44.7 per cent of currency trading in 2016, JPMorgan notes, compared to 60 per cent in 2014. In this sense, currency markets are undergoing the same structural changes seen in equity and bond markets in recent years, with liquidity increasingly being provided by HFT firms. Superficially, this is good for market liquidity, with bid-ask spreads continuing to narrow.

However, HFT firms usually hold onto positions for seconds or even shorter periods of time, in an effort to profit from small price moves; reluctant to risk being the victims of large price moves, they tend to withdraw from the market when volatility erupts. “This creates the risk of a simultaneous withdrawal by HFTs in periods of high volatility or stress or in periods when market become more one-sided,” cautions JPMorgan. Quotes are withdrawn and liquidity disappears, amplifying the initial move and leading to a breakdown in market structure.

Lessons

There are two obvious lessons for ordinary investors. The first is to be wary of leverage; liquidity can vanish in an instant and if a leveraged position takes a sudden turn for the worse, investors face being forced to sell at prices they may have deemed unimaginable.

The second is to be conscious of the dangers posed by stop-loss orders in fast-moving markets. Stop-loss orders are designed to be a risk-reducing measure that automatically cuts one's losses by exiting a position if it moves below a predetermined level. Commonly used by short-term traders, some academic literature also indicates stops can be of use to long-term investors. However, while an investor might have a stop-loss order to sell when a stock falls below a particular level, there is no guarantee the trade will be executed near this price. Following the August 2015 flash crash, the Wall Street Journal reported how one particular investor had a stop-loss order to sell if his ETF fell below $108.69 (€98.62); his order was executed at $87.32 (€79.23) due to there being no buyers in the market. Shortly afterwards, the security rebounded back above $121 (€108).

Limit orders

An alternative approach is to use stop-limit rather than stop-market orders, whereby the stop-loss order is combined with a limit below which you won’t sell. In the above case, the investor could have placed a limit of, say, $107 (€97), ensuring he would not have been at the mercy of a market that had ceased to function properly. The need for brokerages to better educate ETF investors on the advantages of limit rather than market orders was one of seven recommendations made by Blackrock in a report following the August 2015 turbulence. This might protect markets as well as investors. “Excessive use of market and stop-loss orders that seek ‘liquidity at any price’ inflamed the situation,” said Blackrock, which noted the number of market orders were nine times greater than average on that particular day. The same process played out during the sterling flash crash, JPMorgan cautioning that selling was “exacerbated by a cascade of stop-loss activity”. Of course, stop-limit orders are not a panacea for risk-conscious investors, as there is a danger that one’s order is not executed and the stock keeps on falling.

The consolation, perhaps, is that these market vulnerabilities are of less consequence for long-term investors who choose to sit tight. In contrast, those who nip in and out of markets would be wise to not view the recent sterling chaos as an isolated incident. Given the increased dominance of algorithmic and high-frequency trading, the consensus among market strategists appears to be that they will have to get used to occasional flash crashes.