What causes a flash crash?

MOST REGULAR flyers will have experienced an “air pocket”, when their plane hits turbulence and suddenly dips, with unwelcome effects on their heart rate and digestive processes. In financial markets these have become known as “flash crashes” after a particularly volatile day for stockmarkets in May 2010.

But markets can be more stomach-churning than a plane. Prices can not only fall rapidly, but rise equally fast. Whether this is good or bad news for the investor depends on which way they were betting before the turbulence hit.

The latest example came on January 2nd when the Japanese yen rose sharply and the Australian dollar fell. The proximate cause was a profit warning from Apple. This made Asian investors who were nervous about the Australian economy (which is heavily dependent on China) head for the perceived safety of Japanese assets. But trading was very thin, since many investors were still on holiday, and the American markets were closed overnight.

Thin trading, however, is not an adequate explanation for the scale of recent market moves. The Christmas-holiday period has always been quiet for stockmarkets, but in 2018 America’s experienced both its worst-ever Christmas Eve and its best-ever December 26th. Investors were already jittery. After an unusually quiet 2017, there was a lot more volatility in 2018; the S&P 500 suffered its worst December performance since 1946, according to Jonathan Golub, a strategist at Credit Suisse.

In such circumstances, a sharp move can be exacerbated when computer programs, or algorithms, kick in. The simplest of these are designed to limit losses by selling when prices reach certain levels. If enough algorithms have the same parameters, the decline, or rise, can be amplified. Something similar happened in October 2016 to the pound and in January 2015 when the Swiss National Bank abandoned its attempt to cap the franc.

In the past, marketmakers at big banks might have stepped in to limit price moves. But since the financial crisis of 2008, banks have been devoting less capital to trading. In cases of turbulence, investors should keep their seat belts fastened and sick bags close to hand.