Academics Deconstruct the Flash Crash of 2010
Commentary by Steven Lofchie
Three professors analyzed granular data to explore the causes of the 2010 "Flash Crash." They concluded that the crash was caused by "prevailing market conditions combined with the introduction of a large equity sell order implemented in a particularly dislocating manner." In a paper titled "The Flash Crash: A New Deconstruction," the professors supported the findings of a joint CFTC-SEC Staff Report and argued that it is "highly unlikely that, as alleged by the United States Government [in CFTC v. Sarao, that] Navinder Sarao's spoofing orders, even if illegal, could have caused the Flash Crash, or that the crash was a foreseeable consequence of his spoofing activity."
University of California, Santa Cruz Economics Professor Eric M. Aldrich, Stanford University Business Professor Joseph A. Grundfest and University of California, Santa Cruz Astrophysics Professor Gregory Laughlin developed a simulation model that (i) formalized the "insights upon which the [joint CFTC-SEC Staff] Report relied"; (ii) "demonstrated the existence of a market instability when liquidity thins," to which algorithmic traders responded by acting "in concert to drive a rapid, linear decline in price that is very similar to what was observed on May 6, 2010"; and (iii) determined that "such declines are exacerbated by large sell orders."
The professors stated that these conclusions "may have to be amended as a result of further analysis of anomalies discovered in the FINRA Trade Reporting Facility." They provided two interpretations of the data-feed anomalies indicating that the anomalies reflected either (i) a "symptom of the Flash Crash that resulted as traders fell further behind in their reporting obligations in a manner that did not violate rules or regulations in effect in the market" or (ii) a "combination of confusion over transactions prices combined with sharply declining markets [that] could have led algorithmic traders to withdraw liquidity and then to restore it only after this source of price-information uncertainty was resolved."
Commentary
Kudos to the professors for providing a fulsome analysis of the CFTC's assertions. Anyone who possesses common sense and some degree of knowledge of the way in which markets work (including their unpredictability) should have recognized the absurdity of the CFTC and the Department of Justice's assertion that Mr. Sarao caused the flash crash. See, e.g., "Finance Professor Calls CFTC Allegations that Nav Sarao Caused Flash Crash 'Outrageous' (with Lofchie Comment and Video Selection)." Streetwise Professor Pirrong also deserves recognition for pointing out how far-fetched the CFTC's accusations have been from the very beginning.
In its November 2015 press release – long after rationality should have prevailed – the CFTC continued to attempt to pin the flash crash on Mr. Sarao. Let's hope that the regulators will drop their charges against Mr. Sarao soon. Even if he is guilty of the spoofing charges made against him, the government's conduct towards him should be considered. With power, they say, should come responsibility. After all, the damage done by the government's allegation is not limited to the accused. Because of that allegation, the government's resources were wasted and, therefore, we all are damaged. Further, because of the allegation's aftermath, regulators who try to avert future crashes may be sent down a false path when they misidentify the cause of crashes past.
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In the latest installment of the Energy Metro Desk series "Around the Desk," editor-in-chief John Sodergreen discusses the recent charges against Navinder Singh Sarao and the whistleblower award given by the SEC to a compliance officer.
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