Catching a falling knife: an analysis of trading halts

The term ‘flash crash’ has gained notoriety in recent years, but new research suggests a more nuanced picture.

Trading is faster today than ever before, with thousands of orders sent to UK equity trading venues every second.  Infrastructure providers and market participants have invested heavily in technology to gain a competitive edge.  So it is important that regulators keep an eye on the safeguards used by the venues to manage price volatility, and whether they have kept pace with technological developments.

In this paper we use proprietary FCA data to analyse a sample of events where a sharp decrease in the price of a security triggers a circuit breaker on the London Stock Exchange (LSE).  Sometimes these events occur very suddenly – often referred to as a small ‘flash crash’ – but other times they are relatively slow and orderly, or come on the heels of a particularly large sell order.

There are four headline findings to come out of this research.

Firstly, circuit breakers are, broadly speaking, doing their job of helping to cool the market during abnormally volatile conditions.

Secondly, our evidence suggests that, contrary to received wisdom, high-frequency trading (HFT) firms potentially act as a partial stabilising force during these periods, by buying on Lit markets during the price fall. In contrast, large investment banks appear to contribute the most to the price fall by selling heavily during the decline. HFT firms carefully manage their inventory to have a near-neutral inventory position on Lit markets shortly before the circuit breaker is triggered.

Thirdly, our research showed that, for the most part, there is very little trading on other UK lit trading venues when continuous trading on the LSE is not available. This is despite the fact that European law, unlike other jurisdictions, permits market participants to trade on other lit venues when a circuit breaker is triggered on the LSE because of volatility. Our findings suggest that traders are not taking up this option.

Lastly, we found that there is not much trading activity on dark pools compared to lit markets during these events. (And when the LSE is conducting a call auction immediately after a circuit breaker has been triggered, trading in dark pools is effectively suspended.) This is consistent with dark trading generally – it only accounts for a small proportion of total trading.

Forthcoming research by the FCA’s Economics Department is exploring high volatility events (mini-flash crashes and rallies) in UK equity markets in more depth.  The aim is to learn more about how such extreme liquidity shocks unfold and corresponding implications for regulators.  We aim to publish this research by the end of the year.

Note: The views expressed in this article are those of the authors alone, and should not be taken as an official FCA position.

02/08/17