This article was written by Graeme Watkins, CEO of Valutrades.
In the early hours of Friday 7th October 2016 at the beginning of the Asian session, GBP suffered a 10% drop in a matter of minutes. GBP/USD fell from around 1.26 to anywhere between 1.10 and 1.20 depending on your liquidity providers.
The effect was felt across all GBP crosses with EUR/GBP, GBP/AUD, GBP/JPY and other GBP crosses all experiencing similar rapid moves.
Why did it happen?
The initial news commentary cited negative comments from French President Francois Hollande, a fat finger order and rogue algorithms all as possible causes.
In truth these could have all contributed to a market move as could any number of other factors, but none of these alone can cause the phenomenon which we refer to as a flash crash.
How did it happen?
A flash crash is a perfect storm of a trigger, extremely low liquidity, market making algorithms and large stop orders. Under normal market conditions you may have the same trigger and a resultant market move but the depth of liquidity and varying views of market participants will absorb the impact to create a normal market move.
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If the trigger comes and there is no liquidity, as was the case on Friday as it was so early, then the initial reaction will trigger orders that cannot be matched at current market prices so they start matching with bids or offers further and further away from the market price, then the algorithms kick in when they see the moving market and jump on the momentum trying to take a few pips out of the move for themselves and push the market move even further.
Finally, this triggers large stop orders that once hit will send further large market orders creating a snowball effect that will literally continue until every order is wiped out and the market can reset.
Will it happen again?
Until there is unilateral action to change the fundamental rules of trading, as much as any single broker or liquidity provider says they’ve learnt their lesson and have implemented fail-safes, the system is still flawed and the patterns will repeat themselves.
We have already seen most futures exchanges implement circuit breakers but with the FX markets traded on hundreds of separate venues the same solution does not appear viable.
How should we prepare?
As a broker it’s all about making sure we have systems that can keep up with fast market moves to trigger all orders correctly with minimum slippage and having a large capital buffer to absorb any worst case scenarios.
The lesson I think anyone can take away from this is that you need to take a long term view that is well capitalized on low leverage. For example, someone with a balance of 5,000 and a long position of 0.05 lots could still have a long term view that GBP will recover after Brexit is completed and would have been no risk of being stopped out.
By the same respect, any day traders using high leverage to extract value out of a few small pips profit could have had a stop loss in place just under the market price and we saw these orders filled with minimal slippage.