On May 6, the Senate was locked in a heated debate over whether the government should impose size limits on the largest banks in the country, in effect breaking up the reviled giants of American finance. But the journalists in the press gallery above the chamber weren't paying attention: They were riveted to CNBC, which was reporting an enormous, unexpected, and simultaneous plunge in several different global markets. On TV, the Money Honeys were losing it.
The Dow slid 1,000 points in less than an hour. "What the heck is going on?" one reporter wondered aloud. The Senate could break up the banks, and the markets are crashing? It's the end of capitalism!
But capitalism won't go down so easily. Predictably, breaking up the banks was a bridge too far for the stodgy Senate, and the provision only garnered the support of a third of the body. And within a few hours, the markets had recovered their value. Yet a question remained: Why did they plunge 9.2 percent in just a few minutes, only to recover before the day was over?
It's an important issue to resolve, because if we don't understand how our financial markets work, we have no reason to trust them. That is the end of capitalism.
So why the flash crash? There are as many answers as there are financial interests. For people concerned about the state of debt and deficit, the plunge was obviously a response to the Greek debt crisis: Rioters on the streets of Athens had inspired a massive sell-off in the U.S. A few supporters of financial reform wondered if this were an act of financial terrorism, a vigilante -- style protest against financial reform.
The reform-averse made the opposite argument: The mini-crash was caused by Congress considering, even for a second, reining in large banks. The miniature panic, they said, proved that government intervention was dangerous.
On Wall Street, this is called "talking your book" -- trying to get events to match up with the bets on your balance sheet. We're very familiar with the tactic in Washington, where we call it "spinning."
But the politicized explanations didn't have a wide appeal, and soon more divergent ideas emerged. The "fat finger" theory is my personal favorite; it holds that a trader accidentally hit "B" instead of "M" on his keyboard, selling off billions of dollars of Procter and Gamble stock rather than millions and catalyzing the freak-out.
There isn't much evidence this happened, but I rather like to think this is how these things start. Never blame malevolence when there is so much stupidity to go around.
Unfortunately, the Securities and Exchange Commission and the Commodity Futures Trading Commission released a joint report that "found no evidence that these events were triggered by 'fat finger' errors, computer hacking, or terrorist activity, although we cannot completely rule out these possibilities." The report did suggest derivatives called "e-minis" (which sound more like the latest Japanese children's toy than a speculative financial product) were at least partially responsible.
The heads of the two agencies testified before the Senate two weeks after the fact in an attempt to explain what happened. After about 45 minutes of discussing how different market safeguards failed, Sen. Jim Bunning -- who has no business dealing with financial markets -- suggested the protection measures were some kind of bailout. Sen. Jack Reed of Rhode Island stopped the hearing to summarize the state of affairs.
"You're both not quite sure what exactly happened," he said flatly to the two agency heads.
"It is a fair statement," said SEC Chair Mary Schapiro.
The next panel included the heads of the stock exchanges at the center of the slide. None of them knew what happened -- or why -- either.
After the hearing failed to yield any official explanations, I ventured into the fever swamps of the Internet to look for answers. I knew where to go: Zero Hedge, the finance blog whose proprietor, operating under the pseudonym "Tyler Durden," spreads gossip, rumors, and analysis about the dark forces of the financial industry. The site features a handy guide: "How To [Read/Tip Off] Zero Hedge Without Attracting The Interest Of [Human Resources/The Treasury/Black Helicopters]."
Amid the Goldman Sachs conspiracy theories, though, Durden offers some insightful analysis of the high-speed computerized trading that seemed to play a part in the crash. (Sen. Chuck Schumer: "It reminds me of the movie 2001. You started out man and machines, and the machines took over.") Durden has long been a critic of High Frequency Trading (HFT), in which financial institutions use computers and complex trading algorithms to move billions in microseconds in reaction to market developments.
"What happened today was no fat finger, it was no panic selling by one major account: it was simply the impact of everyone in the HFT community going from port to starboard on the boat, at precisely the same time," Durden wrote. "After today investors will have little if any faith left in the U.S. stocks, assuming they had any to begin with. We need to purge the equity market structure of all liquidity -- taking parasitic players."
Purging the financial sector does sound attractive. Many of the latest financial innovations exist in a gray area of regulation and legality that the banks themselves refer to as "dark pools." (Who's in charge of naming this stuff, George Lucas?) The innovations are frightening because they are confusing. And though advocates of these tools say they help markets run more smoothly, most of the firms engaged in HFT simply unplugged their computers when the 2:45 P.M. crash came, providing no help at all.
In fact, the atmosphere in the markets was nothing short of chaotic. Zero Hedge posted an audio clip of a floor trader in action during the flash crash. It sounds like the high-strung comedian Lewis Black calling an auction in a war zone.
"Paper came in -- HUGE PAPER SELLERS COMING THROUGH HERE, guys. ... Here they come; they're selling again! ... Eight halves are trading as well ... eight even offer, seven even offer, six halves, five evens are trading ... three evens are trading now!" The man's voice grows hoarse and high-pitched as prices drop, and you can hear traders shouting in the background. "Guys, this is probably THE craziest I've seen it down here, ever. Guys, that move through the figure was absolutely nuts! ... This will blow people out in a big way like you won't believe!"
By the end of the day, stability seemed to reign. Two weeks later, at the hearing where regulators tried to explain the incident, it all seemed very abstract -- that is until an aide passed a note to Bunning, who brightly observed that once again, the markets were plunging.
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