The “flash crash” in U.S. stock markets on May 6 shocked investors. As one response, it makes sense to coordinate circuit-breakers and other safety switches across trading venues. But the goal shouldn’t be to eliminate sudden drops. Markets are volatile, and smart traders build in a margin of safety. That’s a useful message that is reinforced by the odd surprise.
It’s still not clear what caused the near-thousand-point cliff-dive on the Dow Jones Industrial Average. The most likely explanation is a confluence of factors, including riots in Greece, a decline in the S&P 500 index below an important moving average, an indigestibly large trade in a popular futures contract, and — as the plunge gathered momentum — the disappearance of some high-frequency, high-volume traders from the market.
The bulk of the losses reversed almost as quickly as they materialized. So market forces did, eventually, equilibrate. But one flaw stands out. While market-wide circuit breakers — designed to force a breather in trading when prices move violently — weren’t activated, some other mechanisms covering only parts of the fragmented stock-trading markets did kick in.
On the New York Stock Exchange, for instance, so-called liquidity replenishment points were triggered, forcing trades onto other platforms that didn’t have similar brakes. This may have added to the volatility. Coordinating such tools might help damp irrational market swings in the future.
Other potential fixes offer little protection, however, and won’t come without costs. Deliberately widening bid-ask spreads might concentrate buyers around fewer price points, but would raise investors’ trading costs. Requiring high-frequency traders to stay in the market may have merit, but it won’t stop precipitous drops, the biggest of which happened in 1987, long before such traders existed.
In any case, volatility can be healthy. The “Great Moderation” in the years running up to 2007, notably the extreme predictability of U.S. monetary policy, led to complacency and, ultimately, the credit crunch. Unexpected drops remind investors to operate with healthy margins of safety. That’s a lesson of the recent crisis that no-one should try to regulate away.