In this year alone, there have been 35 bizarre “flash crashes” in American oil markets, essentially meaning that prices dropped significantly and recovered quickly due to automated trading. Prices for West Texas Intermediate crude swung 200 basis points in less than an hour, before recovering at least 75 basis points. Research from the U.S. Commodity Futures Trading Commission (CFTC) shows that these flash crashes are now affecting even the dullest commodities sectors including corn.
Bankers will be tempted to blame regulation introduced after the 2008 crisis making them risk averse and thus reluctant to act as market makers. However, much of the blame for these flash crashes can be attributed to algorithms such as those used by high-frequency traders. In the past few years, the use of automated computer programs expanded so quickly that the CFTC says they are now involved in 50% of all trades for metals and energy futures and 67% of Treasury futures.
The problem is that these automated trading programs lack human judgment. When prices agitate, computers tend to accelerate trading, which incites more flash crashes. In order to prevent flash crashes, policymakers have three options. First, they could turn off automated computers or slow them down via taxation. Second, they could encourage banks to resume their role as market makers. Or, third, they could accept that flash crashes are now inevitable and try to curb their impact by imposing long trading breaks or by trying to spot when computers are about to go haywire.
Even with added regulations, algorithmic trading has become so prevalent in the past few years that flash crashes cannot be truly prevented. The CFTC revealed plans to scrutinize traders’ algorithms and deter those that seem likely to behave erratically when liquidity disappears. The agency also wants greater oversight of high-frequency traders and wants to reinforce circuit breakers that can halt trading in a crisis. These measures are sensible but unlikely to stop flash crashes unless stronger measures are put in place.
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