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A Stock Market Crash Can Happen in a Few Seconds. Are We Prepared?

The oil tanker Sea Isle City had originally been named after a rocky island in the Persian Gulf, Umm al-Maradim, which translates, appropriately if unpoetically, into Mother of Boulders. During the second half of June 1987, she and a number of other Kuwaiti ships were rechristened and began sailing with new names and under the American flag in an effort to deter a bellicose Iran from launching threatened attacks on shipping in the Gulf.

It didn’t work and on Friday, Oct. 16, 1987, Iran attacked, launching Silkworm missiles from the Al-Faw Peninsula that struck the Sea Isle City’s bridge and crew quarters. Sixteen were injured and the captain and a lookout were blinded. Two days later the U.S. Navy responded. Operation Nimble Archer destroyed two Iranian oil platforms being used for surveillance and as bases for helicopter and amphibious patrols. Americans waking up on the morning of Monday, Oct. 19, 1987 thought we were finally at war with Iran.

Our stock market had performed terribly the week before; Friday’s loss of 108.35 in the Dow Jones Industrial Average was the worst point loss ever. Those investors who were uncertain about what to do during that week made up their minds over the weekend; if we were at war it was time to sell. The crush of investors fleeing our stock market on that Monday has now overshadowed the catalyst, which convinced many to sell to such a degree that most have forgotten the attacks ever occurred. By Monday evening the worry was that day’s stock market crash, the worst single day our stock market has ever had, but during the first half of the day it was the promise of war.

Every modern stock market crash has been precipitated by some external catalyst that often seems to have nothing to do with finance. But the 1906 San Francisco earthquake led to a crippling lack of liquidity and spawned the Panic of 1907 as capital flooded the West Coast and fled financial markets. In September 1929 the Clarence Hatry fraud was uncovered in London and stockholders in the U.S. decided over the course of the next month to sell in New York. In 1987 it took a weekend to push investors to sell and in 2010 it took just a day from the May 5 rioting, arson, and murder of three bank employees in Athens, Greece to convince one asset manager in the U.S. to launch an unthinking algorithm which sold $4.1 billion worth of stocks, an unthinkable amount, in just a few minutes. The ensuing Flash Crash drove the Dow Jones Industrial Average, which was already down 300 points for the day, down another 700 in just 13 minutes in the most chaotic crash we’ve known.

A year to a month to a weekend to a single day; it should be no surprise that the time from the catalyst to the subsequent crash has collapsed, just as the time it takes to execute a trade and receive a confirmation has similarly collapsed from days to hours to milliseconds. But this means that with the number of purely algorithmic trading systems at work—none of which have any real-time human oversight and many of which are scanning news and social media for trading cues—the time between the next catalyst and start of the ensuing crash may be just one hour or one minute.

As this time span between catalyst and crash has collapsed, so has our margin of error. Next time we won’t be able to formulate a reasonable policy response, and since only the president and the exchanges have the authority to close our markets early—even the Securities and Exchange Commission doesn’t have this power—we may not even have time for reassuring words from policymakers.

With trading now overwhelmingly automated and algorithmic, this is the time to address the danger—not when the market is crashing and not after the damage is done, even though that tends to be when we find the courage to act. Our varied markets have already displayed a troubling tendency to experience smaller flash crashes. Beside the big one in May of 2010, we’ve also seen crashes in the silver market this July, the stock market in August 2015, the U.S. dollar in March 2015, and the Treasury bond market in October 2014. We’ve been warned.

Flash crashes won’t stop until exchanges make them too expensive for those responsible. The May 6, 2010 flash crash was caused by one institutional investor who stripped all the price and time safeguards from their algorithm; they wouldn’t have done that if the cost was more than just selling at disadvantageous prices. If the investor and their broker were both denied access to markets until they could have certified to exchanges that weaknesses had been fixed, we might have stopped that flash crash in the first place.

Any broker who causes a flash crash should only be readmitted to the market after being subjected to periodic testing of their source code by exchanges to assure it is equipped with the sort of safeguards that are often removed in the desperate search for speed.

Our stock market will crash again, although any crash is likely many years off. But the fact that 20 years passed between the Panic of 1907 and the Crash of 1929, as well as between Black Monday 1987 and the mortgage meltdown of 2008, doesn’t mean we can ignore the hidden weaknesses of purely electronic and algorithmic trading. Remember that it was less than two years from the bottom of that mortgage-inspired meltdown to the flash crash in May 2010.

Algorithmic traders have a responsibility to understand how their systems will react. The exchanges have a duty to make certain they fulfill that responsibility.

Scott Nations is the author of A History of the United States in Five Crashes and the president of NationsShares.