Preventing flash crashes and panic

According to a story put out by Cornell University on Dec. 1, investors, traders and regulators may have another early warning system to help prevent another market crash like the one on May 6. Instead of feeling panic and fear that investments could again be wiped out in seconds, they can rest assured that future "flash crashes" now might be "predictable and possibly preventable" thanks to a metric developed by two professors at Cornell University.

According to the article, "The new so-called volume-synchronized probability of informed trading (VPIN) metric looks at the imbalance of trade relative to the total volume of the market. It identifies flow toxicity." One of the metric's creators, Dr. David Easley, explained flow toxicity as "Flow toxicity refers to the risk that liquidity providers face when trading with traders who have better information than they do," explained Easley. The flow of orders "is considered toxic when traders are selling when they'd rather be buying, and buying when they'd rather be selling."

Supposedly, the metric is able to measure in real-time and could offer exchanges, regulators and traders warnings if the markets are headed toward another crash. It does sound promising and they have interest from regulators and others already.

Saying events like the flash crash are "now predictable and possibly preventable" seems a tall order, though, and one that should probably be taken with at least a grain of salt. We've seen in the past that putting too much faith into any one indicator can be very dangerous, just look at Value at Risk.

It's been almost seven months now since the flash crash happened. In that time we have had reports released, reports debated, fingers pointed and new rules written. A lot has happened in that time. Like most events, though, they loose their impact the further away they become. For a reminder of just what a panic the crash caused, just listen to this recording from the S&P 500 E-mini pits from that day.

Preventing future crashes and investor panic is quite notable, but claiming they may be "predictable and possibly preventable" might be a bit rash. Then again, a skeptic never will find the Holy Grail.

About the Author
Michael McFarlin

Michael McFarlin joined Futures in 2010 after graduating summa cum laude from Trinity International University, where he majored in English/Communication. With the launch of the new web platform, Michael serves as web editor for the site and will continue to work on the magazine, where he focuses on the Markets and Trading 101 features. He also served as a member of the Wisconsin National Guard from 2007 to 2010. mmcfarlin@futuresmag.com

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