

Why the Flash Crash Really Matters - dnetesn
http://nautil.us/issue/23/dominoes/why-the-flash-crash-really-matters

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ChuckMcM
Ok, I read that twice, is the summary "The market is a complex tightly coupled
system." ?

I get that, and I get such systems can be subject to anomalous events (early
fly by wire systems for dynamically unstable aircraft was a good test case to
study). But such systems can also be 'calmed' by damping. Isn't the SEC in
charge of adding such damping to our financial trading systems?

~~~
clearf
One of the authors here. I think that's a pretty good summary. And, yes, I
agree that there are ways to introduce damping into many such systems and some
has been added since the Crash, as another comment points out.

I think it would be great if the SEC believed that that was their mandate.
Unfortunately, I think that is predicated on much more sophisticated and
nuanced understand of the dynamics of the markets than regulators typically
have.

The claim in the recent CFTC's Complaint that alleged market manipulator
Navinder Sarao directly contributed to the crash is only one example of this.
If one guy can cause a Flash Crash, there is a bigger problem with the
structure of the markets.

~~~
minimax
I'm curious whether you have seen this speech from last year given by Gregg
Berman who was, until recently, an associate director in the division of
Trading and Markets at the SEC.

[http://www.sec.gov/News/Speech/Detail/Speech/1370541505819](http://www.sec.gov/News/Speech/Detail/Speech/1370541505819)

I think it shows that the regulators (at least some of them) do want to have a
better understanding of the dynamics of the US equity market, and that they
are trying to build the tooling that will give them the right sorts of
insights. Berman's suggestion that policy changes ought to be driven by data
are, I think, something that most technologists would agree with. For whatever
it's worth, Berman also has a physics Ph.D. from Princeton. So if your
insinuation is just that the regulators are more lawyer than scientist I don't
think that's completely true.

edit: Also wanted to add that there has been a lot written about the flash
crash and I think this article is definitely one of the better ones.

~~~
clearf
I have heard Gregg Berman speak, though I hadn't read this speech until
skimming it just now. I do think that there is, generally speaking, a
heartfelt desire to develop the tools and data needed to gain insights that
Berman is talking about.

I think there are two challenges to unpack. One, though I wasn't insinuating
it, I could have been. I do believe that regulators are more lawyers than
physicists. Berman is the exception rather than the rule.

Two, Berman, in particular, makes a fundamental error that I think is very
easy to make. There's a difference between "complex" in the sense that
something has a lot of parts, and interactively complex in the sense that
parts of a system are fundamentally unknowable and it can experience wild and
unexpected dynamics. I think Berman doesn't distinguish between those two
types of systems (repeated analogies to cell phones give some indication of
his thinking), and more generally, regulators don't understand the aggregate
cost of complexity.

In my view, things like Midas are orthogonal to some deeper issues facing the
markets. Regulators have created a quasi-competitive market that breeds this
sort of interactive complexity. Then, when something goes wrong, they rely on
punishment and enforcement actions [1] to target individual firms that have
made "mistakes." This not only does not address root causes, it creates a
culture of silence around technology risk issues within firms and across the
industry. I've written more about this here:
[http://harvardkennedyschoolreview.com/preventing-crashes-
les...](http://harvardkennedyschoolreview.com/preventing-crashes-lessons-for-
the-sec-from-the-airline-industry/)

[1] See, e.g.,
[http://www.sec.gov/litigation/admin/2013/34-70694.pdf](http://www.sec.gov/litigation/admin/2013/34-70694.pdf)
and
[http://www.sec.gov/litigation/admin/2013/34-69655.pdf](http://www.sec.gov/litigation/admin/2013/34-69655.pdf)

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codeulike
When events are happening at the microsecond scale, its not really a 'market'
anymore, its more like a casino. Its just some game with arbitrary rules that
various actors are trying to win via different strategies. The link to any
real world concept of 'investing in companies' is very weak when positions are
only held for the very short term.

~~~
kasey_junk
Why do you assume the markets are about investing in companies? They are in
fact very much not about investing in companies. Even the closest analog a
single share, doesn't represent an investment in the company. The company got
it's investment many many transactions ago, when it offered the shares
originally.

~~~
kd5bjo
Well, they're (usually) about taking over someone else's investment. In
theory, each share should be priced at the present value of future dividends,
all the way forward to the company's eventual liquidation -- if market price
is below your estimate of this, you should be buying; if above, you should be
selling.

~~~
kasey_junk
Right, but what you are now talking about risk and liquidity. Most market
transactions have nothing to do with investment in companies, they have to do
with pricing risk. That it makes it easier for companies to find investments
in some cases is a beneficial impact of this, not it's main focus.

It is a particularly HN bias to think of the market as a place to go fund a
company, but that is largely a by product for most people. For most people
(including everyone with an index fund/etf) its a place for managing risk.
That doesn't even take into account, that a big component of this story was
about S&P _futures_. Which are all about risk.

So it is uninteresting (even if it were true, which i doubt) that microsecond
time scales make the markets less about investing in companies, they already
aren't about that.

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danbruc
Aren't markets expected to figure out the true price of things and do other
similar stuff? And doesn't that imply that the state of the market should
always be close to the global optimum and market force should drive it even
further into this direction? Sounds very much like a stable system to me, so
how can it run away unless the current state is just a local optimum and a
correction to the global optimum - or a better local optimum - happens?

~~~
evanpw
The vast majority of the time, this is true. Notice that after the Flash
Crash, most prices came back to basically where they started within a few
minutes.

At the micro level, the problem is uncertainty. The "true" or "fair" price of
a security isn't something you can just calculate: it's uncertain and subject
to change when new information is introduced into the system. So
theoretically, when the price gets very far from the fair value, market makers
should become more and more eager to trade, since they'll make a large profit
when the price comes back. But in practice, they never know whether the person
on the other side of the trade is just panic-selling and moving the price
farther from equilibrium, or if they know something the market maker doesn't
and are moving the price closer to a new equilibrium. As the price gets
farther from its previous stable value, the probability that the counterparty
is informed grows, and eventually no market maker is willing to trade and the
market dissolves.

This failure mode is related to the "Market for Lemons" problem: asymmetric
information causing a market breakdown
([http://en.wikipedia.org/wiki/The_Market_for_Lemons](http://en.wikipedia.org/wiki/The_Market_for_Lemons)).

