The 2010 Flash Crash – What It Was and the Causes Behind It

What is a flash crash?

 

A flash crash is a rapid – usually not more than a few minutes – decline in price due to a massive sell-off, followed by a quick recovery.

A few examples of flash crashes from the recent past:

  • 2010 flash crash on equity futures and the overall equity market
  • 2013 Singapore Exchange flash crash
  • 2015 flash crash on ETFs
  • 2017 Ethereum flash crash

The 2010 flash crash

 

One of the biggest flash crashes in history was the 2010 flash crash on equity futures and the overall equity market. During the event, the Dow Jones Industrial Average (DJIA) dropped more than 1,000 points and then recovered most of it in around 15 minutes.

Timeline of events

The flash crash in 2010 took place on May 6 and lasted a total of approximately 30 minutes.

At around that period, there were overall economic fears on the market due to the Greek debt crisis, and on that day specifically markets opened lower as well, with a general decline in numerous stock prices.

At around 2:30 p.m. on that day, liquidity evaporated on futures contracts. The E-mini S&P 500 (ES) buy-side liquidity fell from $6.0 billion to $2.7 billion, and the VIX index, which measures market volatility, increased by 23%.

Between 2:32 and 2:45 p.m., the majority of the flash crash occurred. An enormous sell order of 75,000 E-mini contracts, worth $4.1 billion, hit the market at once, without being split into smaller amounts. This caused the ES price to fall 5%, causing market arbitragers to sell on the spot market, leading to a 6% drop in the price of the S&P 500 Trust ETF (SPY).

Next, in a chain of events, liquidity on the market dropped even further, market makers and other liquidity providers widened quoted spreads, reduced offered liquidity, or even completely withdrew from transacting.

As a consequence, several stocks traded at unusual prices. Some dropped down to $0.0001 while others increased to $100,000. The most visible price decline was that of the Dow Jones Industrial Average (DJIA), which dropped 1,000 points.

At 2:45 p.m., trading halted on the Chicago Mercantile Exchange (CME) and the trading of E-mini was stopped, leading to a stabilization of prices.

Potential causes

The cause for the 2010 flash crash cannot be reduced to one single element, it was caused by multiple complex causes at once.

  • One of the causes was the huge sell order issued on the E-mini contracts by the Waddell & Reed mutual fund, which wanted to hedge their $75 billion investment portfolio.
  • Another cause is said to be the market manipulation of Navinder Sarao, a stock market trader, who caused limit order imbalances by adding orders to the book that he did not intend to execute. This method is called spoofing, which under the 2010 Dodd-Frank Act is defined as “the illegal practice of bidding or offering with the intent to cancel before execution”.
  • Regulators have also revealed that even though they were not involved in the outbreak of the flash crash, high-frequency trading firms added to the price decline. Since high-frequency traders account for over half of all US equity trading, their aggressive withdrawal from the market highly affected market liquidity, thus contributing to the flash crash.

New regulations

In the wake of the 2010 flash crash, several new regulations were passed. Two examples:

  1. Regulators have installed a Limit Up-Limit Down Mechanism (LULD), which prevents trades from occuring outside of a specific price band. These price bands double during the opening and closing periods.

  2. The Market Wide Circuit Breaker Revisions (MWCB), which halt trading during a severe market decline, were also installed somewhat later, in 2012. These circuit breakers came into effect several times during the COVID-19 pandemic, for example.

 

Bottom line

 

Flash crashes have occurred numerous times in the past and are likely to happen again in the future. As an investor, the best thing you can do if you witness a flash crash is to not panic. Although during a flash crash prices usually drop significantly, they recover rather fast afterward.

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