You see them all the time these days in stocks and shares.
It’s not unusual to see a market sell-off insanely only to bounce back moments later.
They even have their own special name: flash crashes.
It’s easy to blame the big players – investment banks and the like – for ganging up on us smaller guys, running our stop losses and costing us trades.
But are there actually more sinister forces at work in the markets?
What actually happens in a flash crash?
Flash crashes are a by-product of modern technology. Much trading at an institutional level is now done on autopilot: an algorithm is pre-programmed into a computer so it can think and trade for itself.
The idea is the computer knows how many shares or contracts should be bought or sold when the markets behave in a certain way.
But if the market price can be manipulated – through fake or ‘spoof’ orders – it can deliberately trigger the algorithms.
The snowball effect of these sell orders hitting the market then sets off a chain reaction…
The price drops lower triggering the next batch of computer orders; their sell orders come in and send the market lower again.
The market is crashing – fast – and any buyers in the market would understandably pull their buy orders at this point – they don’t want to be left catching a falling knife. And the sell-off gathers momentum and tumbles lower at ever increasing speed.
In theory it would only stop when all the computer sell orders are exhausted or when enough buyers eventually step in to match the selling pressure.
Could computer hackers deliberately engineer this?
Here’s Jim Rickards explaining how they could do it and the effect it would have on the market:
An attacker could penetrate the order entry system of a major stock exchange such as the New York Stock Exchange or one of the order-matching dark pools operated by major investment banks, such as the SIGMA X system controlled by Goldman Sachs. Once inside the order entry system, the attacker would place large sell orders on highly liquid stocks such as Apple or Facebook.
Other system participants would then automatically match these orders in the mistaken belief that they were real trades. The sell orders would keep flooding the market until eventually other participants lowered their bids and began to deflect the selling pressure to other exchanges.
The result could be a market decline of 20% or more in a single day, comparable to the stock market crash of October 1987 or the crash of 1929.
So this is the exposed underbelly of computerised trading.
At the moment, those institutions with the most powerful computers and the quickest connection to the exchange have an edge over all other market players. Processing speed is a mini arms race in its own right.
But it could all be rendered useless by a hacker in China with some smart coding skills and an old dial-up modem!
So what can be done about the threat of Financial Warfare?
Jim suggests a back-up plan…
I recommended that the SEC and New York Stock Exchange buy a warehouse in New York and equip it with copper-wire phones, handheld battery-powered calculators, and other pre-Internet equipment. This facility would serve as a non-digital stock exchange in the event of a digital attack.
Orders would be phoned in on the analogue phone system and put up for bids and offers by the specialists to a crowd of live brokers. This is exactly how stocks were traded until recently. Computerised and algorithmic trading would be banned as nonessential.
Only real investor interest would be represented in this non-digital venue.
The U.S. would let China and Russia know this facility existed as a deterrent to a digital attack in the first place. If our rivals knew we had a robust non-digital Plan B, they might not bother to conduct a digital attack in the first place.
Now I think it’s a bit optimistic to think the baddies would simply shrug their shoulders and slope off to find other targets just because a ‘plan B’ is announced.
But I do love the idea of an analogue exchange. It brings back fond memories of a simpler time when I used to fax orders in to my futures broker.
And that wasn’t too many years ago either!
He also makes a valid point that an analogue exchange would cut out all the manipulations and spoof orders. They simply wouldn’t be able to push the stock markets around like they do at the moment with dummy orders placed and pulled inside fractions of a second as the computers try to outwit each other.
So it could even make for a refreshing change: a return to ‘truer’ and more transparent markets!
What do you think? Are we in danger of losing control of our technology and the financial assets that rely on it?
Drop me an email: email@example.com. I’d love to hear your thoughts.