Due diligence in the age of flash crashes

May 6 will be the fifth anniversary of an event most advisers would like to forget: the 2010 Flash Crash, which resulted in stock market losses of nearly $1 trillion, with the market largely recovering within minutes.

Because the event didn’t result in any palpable difference to account balances, it may seem like a blip to the average investor. But between 2:40 p.m. and 3:00 p.m. that day, more than 2 billion shares were traded as market liquidity evaporated, aggravated by high-frequency selling orders that found no matching buyers.

Near the end of this episode, many retail orders were left at the mercy of price swings of as much as 60% from their 2:40 p.m. levels. After the market close, the stock exchanges and the Financial Industry Regulatory Authority Inc. met and jointly agreed to cancel all those transactions under “clearly erroneous” trade rules.

A joint inquiry by the Securities and Exchange Commission and Commodity Futures Trading Commission pinpointed the problem as originating with an automated trade by a large fund complex.

But not everyone agrees with that explanation or whether we can expect another “fat tail” event.

Several minicrashes have been reported here and in other countries since 2010. The most recent, in November, involved just over 100 U.S. stocks moving 1% within a single second before stabilizing.

FASTER AND FASTER

Trading speeds have increased exponentially over the decades. According to the Bank of England, the average speed of order execution on the New York Stock Exchange was 20 seconds a decade ago versus one second today. Electronic trading platforms measure execution times in microseconds.

High-frequency trading, in turn, has grown from a tiny share of the market in 2005 to an estimated 35% of trading volume today. The higher speed and volume of trades, shorter holding periods, and the interconnectedness of trading across markets pose growing risks to market stability and integrity.

Regulators have taken note. With computers’ having assumed much of the day-to-day decision-making in market trading, regulators struggle to address the risks of algorithmic trading.

But it takes time to design, implement and refine circuit breakers to contain flash events, create audit trails, streamline the process for canceling “clearly erroneous” trades and explore other controls, such as new transaction fees.

At the same time, investment advisers and managers must adapt to meet their fiduciary obligations to clients.

In some cases, as new technology brings different investment risks, technological and business innovations emerge to counter them.

For example, high-frequency trading has been driven by the possibility of traders’ gaining an exploitable time advantage by seeing and acting on order information a split second before other participants.

This development has opened the door to alternative trading systems, such as IEX, offering a venue that levels the playing field for investment managers.

For advisers, the fiduciary obligation of due care requires following a prudent process to serve clients’ best interest. That includes managing risks and opportunities that arise from marketplace developments.

Translated into practice, advisers must stay current and adjust their due-diligence procedures to deal effectively with the ramifications of new technologies.

Whereas due diligence once focused almost entirely on selecting asset classes and securities, technology has forced a much broader perspective that includes taking a closer look at relationships with service providers.

Given the almost-daily reports of cyberattacks on financial institutions, proper due diligence should include consideration of cybersecurity protections that key service providers have in place.

Similarly, the SEC and Finra have announced their intention to assess business continuity and data-protection programs in the industry.

Advisers have a critical role in this new phase of what one academic paper describes as the need to “better manage the velocity of cyborg finance.”

On the retail level, advisers should re-evaluate service provider selection and monitoring criteria. They should also overtly consider large loss scenarios in portfolio construction and procedures to manage client expectations in an era of increasing market volatility.

Blaine F. Aikin is president and chief executive of fi360 Inc.