Technology has transformed the way financial assets are traded. Both markets and trading strategies are automated and algorithmic in nature. “Market dislocations are happening faster than the speed of human cognition,” noted SMU Cox finance professor Mehrdad Samadi and his co-authors. In new research forthcoming in the Journal of Finance, the authors parse second-by-second trading in the bellwether E-mini S&P 500 futures market before and during the infamous Flash Crash of May 6, 2010, shedding light on the trading ecosystem. The findings will help inform policymakers’ rulemaking to prevent future crashes and better design market structures.

In the research, granular, account-level data were used to shed light on what type of traders were trading and when. Since equity markets are increasingly fragmented, a share of IBM can be traded at over 40 venues, with no consolidated account-level database across venues, notes Samadi. The CME Group E-mini market is one that contributes heavily to overall stock market price discovery, making it an ideal market to study.

Technology has transformed the way financial assets are traded. Using a novel, data-driven trader classification approach, the authors cataloged trading accounts based on how they trade. They examined market intermediaries such as high-frequency traders (HFTs) and market makers to make sense of the day of the crash. The function of intermediation has been increasingly provided by market participants without formal obligations, like HFTs, a change in what was once traditional trading behavior. In the study, HFTs were approximately one-third of the trading volume, and about 30 percent on May 6. Other traders were classified as small traders, fundamental buyers, fundamental sellers and opportunistic traders.

Theory suggests that market crashes can occur if there are large and temporary selling pressures. If a small imbalance exists, then market intermediaries are supposed to provide a liquidity function to smooth the imbalance. “However,” explains Samadi, “market makers have limited risk bearing capacity.” If this capacity is overwhelmed, then liquidity crashes can occur, resulting in wild fluctuations in prices in the absence of big news on the fundamentals.

A major misconception of HFTs, according to Samadi, was that they were just the new, electronic version of the specialists (or market makers) that were traditionally observed on the floor of the NYSE, but the data suggested otherwise. “We have evidence that they exhibit high-frequency market timing. They can buy before market [prices] increase and sell before market [prices] decrease, and close out their position — that does not fit with traditional market maker behavior,” Samadi noted about the HFT accounts.

As the speed of trading has surpassed human cognition, Samadi says, “Policies and trading rules need to be better designed to stop crashes before they happen.”