2/15/2021 The Stock Market Was Rocked by a Mysterious ‘Flash Crash’ Five Years Ago.
ash Crash’ Five Years Ago. What You Need to Know. | Barron's
MARKETS
The Stock Market Was Rocked by a
Mysterious ‘Flash Crash’ Five Years Ago.
What You Need to Know.
By Evie Liu
Updated Aug. 24, 2020 6:46 am ET / Original Aug. 23, 2020 11:40 am ET
Monday marks the fifth anniversary
of the stock market’s last major
“flash crash.”
Today, the capital markets seem to
be in a healthier place. Changes to
market structure, implemented in
response to the 2015 seemed to
help avoid another similar
Photograph by Michael Nagle/Bloomberg
occurrence during stocks’ sharp
selloff in February and March. And one market-structure expert is confident the
markets can withstand future tests, as well, whenever volatility inevitably returns.
What Happened Five Years Ago
On Monday, Aug. 24, 2015, the S&P 500 opened at 1965.15. Within minutes it fell
by 5% to a low of 1867.01. The market regained most of the losses intraday but the
dropped again toward the end of the session, finishing 3.7% below the open.
Similarly, the Dow Jones Industrial Average dropped nearly 1,100 points in the first
five minutes of trading and closed the day 588 points, or 3.6% lower. The indexes’
single-day drop wasn’t unheard of, but the speed of the selloff was uncommon,
and unnerving, for traders and investors.
Heading into the “flash crash,” the market had already experienced strong bouts of
selling, falling 5% from Aug. 19 to Aug. 21. Overnight, on Sunday, Aug. 23, the
Chinese Shanghai Composite Index tumbled 8.5%. The large drop in Asian stocks
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caused many traders to panic and triggering a selloff in European and U.S. futures.
Before the U.S. market opened on Monday, stock futures were deep in negative
territory.
The problems were compounded by a lack of bids to meet the large amount of sell
orders overnight. Investors had been bearish and hesitant to buy. On top of that,
late August typically brings lighter trading volume, with much of Wall Street on
vacation.
The lack of liquidity pushed trading prices lower for many stocks and caused other
New York Stock Exchange-listed stocks to delay their opening. With some stocks
trading and others not, many exchange-traded funds were unable to calculate their
net asset values and trade at the correct price.
That caused a further crunch in liquidity, as many market participants—including
ETFs—paused trading when they detected extreme pricing anomalies that they
couldn’t understand or verify. As prices continued to fall, more traders put in sell
orders to avoid further losses. Without enough buyers on the other end, market
orders were executed at prices way below the prior session’s closing price.
What’s Improved Since 2015
While the 2015 “flash crash” was a series of unfortunate events, there were
deficiencies in market structure that failed to stop the crash and even contributed
to it.
For example, not all of the exchanges had opened at the same time. Although
stocks and ETFs are listed on one exchange, their trades can happen across many
exchanges. Most exchanges open automatically at 9:30 a.m., but the New York
Stock Exchange has a “hybrid mechanism” that incorporates some human
judgment to ensure the integrity of an opening price. That approach, however,
allowed opening delays during extreme volatility. That’s what happened on Aug.
24, 2015.
At the time, the S&P 500 index only used prices from stocks’ primary exchange for
calculation, says Kim Russell, market structure specialist at State Street Global
Advisors. That means if the stocks listed on the NYSE opened late, the S&P 500
would quote their prices from the previous session, even if they had already started
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trading on other exchanges at different prices. “There was a divergence there,”
Russell says.
On Aug. 24, 2015, for instance, while many individual stocks had fallen significantly
in the opening minutes, the S&P 500—still citing Friday’s price—didn’t reflect that.
The index had only dropped 5%, and that wasn’t enough to trigger the market-wide
circuit breaker in place, which requires a 7% decline. Marketwide circuit breakers,
the particular mechanism designed to help stabilize markets, never kicked in
during the 2015 “flash crash.”
Today, the S&P 500 accounts for stock prices across all market exchanges. That
means even if a stock is delayed in opening on the NYSE, its price won’t be missing
or lagging. “As a result of this change, we saw earlier this year four instances of the
market-wide circuit breakers, which helped stabilize the markets during the
pandemic-related volatility,” Russell says.
The “limit-up, limit-down” mechanism is another key measure that’s meant to help
mitigate stock volatilities. Introduced after the first “flash crash” in 2010, the
mechanism sets price bands for each individual stock using the average price over
the preceding five-minute period as a reference point. If transactions are unable to
occur within that range, the exchanges would halt the trade for a five-minute
period, serving as a single-stock circuit breaker.
During the 2015 “flash crash,” however, many stocks and ETFs—especially the
thinly traded ones—were unable to determine the fair reference price at the
opening because no trade occurred in those initial minutes. In such cases, these
securities had to use the midpoint of the opening bid-ask quotes, which is often far
from the stock’s actual value. As a result, many securities—after reopening from a
previous halt—fell immediately into another one.
The exchanges have since filed amendments to fix the “limit-up, limit-down” rule,
now using the previous day’s closing price as the reference point in such cases.
The exchanges also extend the trading halt if the market suggests reopening prices
would fall outside of the guardrail. Exchanges will widen that price range gradually,
giving market participants enough time to reassess the situation, while allowing
time for additional liquidity. Research in recent years shows that these changes
have resulted in a significant reduction in the number of trading pauses.
Could It Happen Again?
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As stocks tumbled earlier this year in the midst of the coronavirus pandemic, the
changes made to market-wide and individual stock circuit breakers helped them
function as designed. The S&P 500 suspended trading four times during the March
volatilities—on March 9, March 12, and March 16 within the first five minutes of
trading, and on March 18 around midday.
“The Covid-19 volatility was a test, and those mechanisms passed the test,” Russell
says. “If we see increased volatility again this year, investors should have
confidence based on what they saw earlier this year that the market will operate
smoothly.”
Write to Evie Liu at [Link]@[Link]
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