Hey, so, have you heard of the 2010 flash crash?
When a slapdash backlash trashed the market’s cash?
No?
Then here’s a brash rehash.
So, on May 6, 2010, mostly as a result of Greece pulling some classic Greece moves,
the stock market was having a pretty bad day.
But then, at 2:32 pm, for seemingly no reason at all, the market started dropping like,
in the words of economic expert Calvin Broadus Jr, it was hot.
In the four minutes from 2:41 to 2:44 alone, it lost 300 points, and by 2:45 it had gone
down a total of 600 points.
But then, like Jesus after his famous three-day nap, it started to rise, and by 3:07, it had
almost completely recovered.
Basically, in a span of 36 minutes, $1 trillion dollars disappeared and then reappeared like
it was Jeremy Piven’s hairline.
So… what happened?
Well, according to a controversial––we’ll get to that later––SEC report, this trillion
dollar now-you-see-me now-you-don’t act can be traced to a firm called Waddell and
Reed Financial selling $4.1 billion in e-mini S&P 500 futures contracts.
That’s a lot of words, but basically, they’re just contracts tied directly to the overall
value of the S&P 500— which is an index, used as a tool to see how the market’s doing
as a whole, composed of the 500 biggest stocks on the stock market.
And the good folks at Waddell and Reed Financial, or WARF, as I and nobody else calls them,
decided that instead of doing the trade by having some poor intern click a button for
half the day, they would have a sell algorithm handle it.
Now normally, a trade that big would happen slowly, over like 5 hours, but apparently,
WARF had taken a sort of Bob Marley approach and told their algorithm not to worry about
time, or about price, for that matter––so it just started selling the contracts as fast
as possible at whatever price was out there.
As you may remember from the economics lecture your dad gave you when he refused to invest
in your lemonade stand, supply and demand means that when a ton of contracts get sold,
especially very quickly, prices tend to dip.
“But Sam” you scream at the top of your lungs, “how did a $4 billion trade turn
into a $1 trillion loss?”
Well, the problem of this dumb algorithm was made worse by, you guessed it, other dumb
algorithms––in particular, ones called high-frequency trading algorithms, which are
designed to make lots of trades very quickly.
Often, HFTs serve as something called “market makers”––basically middlemen, who buy
up an asset when it's being sold, so that when buyers show up, they can turn around
and sell it to them, and pocket any price difference.
Now, seemingly, most of the $4.1 billion of contracts that WARF sold were quickly bought
by HFTs, but here’s the thing: HFTs don’t actually like to hold contracts––their
whole thing is buying them and then immediately selling them.
So what happened was, a bunch of HFTs started unloading the contracts onto… other HFTs,
who then unloaded those contracts onto other HFTs, and so on and so on until the contracts
were basically being passed around and around and around like a toxic, market-destroying
hot potato, driving down prices and creating chaos.
And that led to a new problem: a lot of the algorithms that serve as market-makers reached
pre-programmed thresholds that forced them to exit the market, because prices were dropping
so fast and risk had gotten too high.
And when the market makers pulled out, it massively reduced liquidity, which meant the
market plunged even more.
Now, so far, I’ve been talking about the futures market, and I told you at the beginning
that the stock market collapsed.
Well, that wasn’t a mistake.
I don’t mank mistakes.
The futures crash bled into the stock market thanks to a group of jerks called arbitrage
traders.
You see, when you buy a future, you’re really buying a stock that you just get later.
Arbitrage traders saw S&P futures contracts getting cheap, while the S&P stocks that make
up those futures were still expensive.
So, they started selling their expensive regular stocks to buy the cheap future version of
the same stocks, and all that rapid stock selling basically transferred the futures
crash over to the stock market.
So, why did it end?
Well the same reason Kim and Kanye’s marriage ended: thanks to the Chicago Mercantile Exchange’s
“Stop Logic Functionality.”
Basically, the CME has a mechanism where, when everything starts going nuts, they force
trading to stop so that everybody can have a juice box and think about what they’ve
done.
After a five second stop at 2:45 pm, when trading resumed, the panic had subsided, and
people realized that stocks had gone down for no good reason, which now meant that stocks
were basically available at a discount, which meant everybody went and bought them, which
pushed the price right back up to where it had been before.
So there you go: the flash crash, explained.
Unless Vox has copyrighted “explained.”
Uh… the flash crash… said how it works.
Exceeeept… everything I just told you is actually just one theory of what happened.
It’s probably the most complete theory, and it’s the one that the SEC stands by,
but… the truth is, even eleven years after the flash crash, there isn’t consensus about
what caused it.
The SEC report received a lot of criticism from some pretty legitimate institutions,
including the Chicago Mercantile Exchange.
And while published peer-reviewed academic research offered an explanation centered on
something called order flow toxicity, that was later called into question by further
peer-reviewed research.
And there are a ton of other theories, involving decentralization, spoofing, and technical
glitches.
In the end, the real takeaway is that financial markets that literally undergird human society
have become so complicated and insane and fragile that they can wipe out $1 trillion
in value, then add it all back in 36 minutes, and nobody will ever be totally sure why.
Which… isn’t a very funny conclusion, so here’s a Spot-the-Difference game.
Can you spot the difference between these two SEC logos?
That’s right: it was a trick question.
They’re the same.
Now, there is one other really weird part of the flash crash: for a short period, a
bunch of blue-chip stocks, worth about $40-ish, started selling for literally one penny, while
at the exact same moment, a few similar other stocks started trading for $100,000.
But the thing is, we have to keep these videos pretty short or our all-knowing Lord and Savior,
the YouTube algorithm, will punish us.
But don’t fear: I made a whole four minute video about it that you can watch right now
on Nebula.
Of course, the best way to get Nebula is through the CuriosityStream/Nebula bundle deal, where
for less than $15 a year, with the current sale, you also get access to CuriosityStream,
the documentary streaming service with fantastic content, like the very funny yet still somehow
educational series Nigel Latta Blows Stuff Up.
Of course, on Nebula we also have exclusive companion videos, all our normal videos early
and ad-free, and big-budget Nebula originals—and you get that all not only from HAI, but from
all the other independent creators you’ll be supporting.
So, go get the best deal in streaming, and enhance your HAI viewing experience, by signing
up at CuriosityStream.com/HAI.