RiskTech Forum

CASS & HEC Study into Flash crash reforms find they will fail to make markets safer

Posted: 18 October 2012  |  Source: Finextra

A new piece of academic research by CASS Business School and HEC School of Management find the new circuit breaker system designed to avoid a repeat of 2010's flash crash will fail to avert another market meltdown unless it is coupled with 'liquidity safety valves'.

The SEC initially introduced circuit breakers in responce to the May 2010 flash crash sending the S&P 500 index plummeting in minutes. This circuit breaker pauses trading in stocks if their prices change by more than 10% in five minutes.

Next year these will be replaced with a 'limit up-limit down' mechanism, where trades in listed stocks will have to be executed within a range tied to recent prices for that security.

But researchers from London's Cass Business School and the HEC School of Management in Paris argue that the limit up-limit down system will not be enough to prevent another rout because the advent of high frequency trading has led to markets becoming progressively intertwined.

Co-author Giovanni Cespa says: "This liquidity evaporation may materialise in one market first, triggering a spiral that drags all assets into the illiquid regime. Price based circuit breakers do not necessarily offer a good protection against such illiquidity spirals because the latter may happen without trades and therefore without changes in prices."

To counter this risk, Cespa and co-author Thierry Foucault call for new 'illiquidity-based circuit breakers' in tandem with price-based ones. This would mean trading could be stopped when market-wide depth falls below a specified threshold.

"It could be an effective way to block an illiquidity spiral at its inception and thereby help traders to re-coordinate on a regime with higher liquidity," adds Cespa.